A nonlinear model of asset returns with multiple shocks

Abstract

A nonlinear model of asset returns allowing for multiple shocks is specified. The nonlinear features of the model are demonstrated graphically using a 3-dimensional diagram referred to as the mean impact surface. A new class of nonlinearity tests is also developed which is compared with existing testing methodologies. Applying the framework using excess returns on US and world equities the empirical results provide strong statistical evidence that domestic and foreign shocks have nonlinear effects on expected returns in the US with the effects being determined by the sign and the size of shocks. In contrast, the effects on world expected returns from shocks in the US and the world are found ..