Regime switches in the risk–return trade-off

This paper deals with the estimation of the risk–return trade-off. We use a MIDAS model for the conditional variance and allow for possible switches in the risk–return relation through a Markov-switching specification. We find strong evidence for regime changes in the risk–return relation. This finding is robust to a large range of specifications. In the first regime characterized by low ex-post returns and high volatility, the risk–return relation is reversed, whereas the intuitive positive risk–return trade-off holds in the second regime. The first regime is interpreted as a “flight-to-quality” regime.