Abstract
In this paper we develop a new approach within the framework of asset pricing models that incorporates two key features of the latent volatility: co-movement among conditionally heteroskedastic financial returns and switching between different unobservable regimes. By combining conditionally heteroskedastic factor models with hidden Markov chain models (HMM), we derive a dynamical local model for segmentation and prediction of multivariate conditionally heteroskedastic financial time series. The EM algorithm that we have developed for the maximum likelihood estimation, is based on a Viterbi approximation which yields inferences about the unobservable path of the common factors, their variances and the latent variable of the state process. Extensive Monte Carlo simulations and preliminary experiments obtained with a dataset on weekly average returns of closing spot prices for eight European currencies show promising results.