Testing for Cointegration in Nonlinear Star Error Correction Models

U of London Queen Mary Economics Working Paper No. 497

27 Pages Posted: 31 Aug 2003

See all articles by George Kapetanios

George Kapetanios

King's College, London

Yongcheol Shin

Independent

Andy Snell

University of Edinburgh - Economics

Date Written: July 2003

Abstract

In this paper we propose a new testing procedure to detect the presence of a cointegrating relationship that follows a globally stationary smooth transition autoregressive (STAR) process. We start from a general VAR model, embed the STAR error correction mechanism (ECM) and then derive the generalised nonlinear STAR error correction model. We provide two operational versions of the tests. Firstly, we obtain the associated nonlinear ECM-based test. Secondly, we generalise the well-known residual-based test for cointegration in linear models by Engle and Granger (1987) and obtain its nonlinear analogue. We derive the relevant asymptotic distributions of the proposed tests. We find via Monte Carlo simulation exercises that our proposed tests have much better power than the Engle and Granger test against the alternative of a globally stationary STAR cointegrating process. In an application to the price-dividend relationship, we also find that our test is able to find cointegration, whereas the linear-based tests fail to do so. Further analysis of impulse response functions of error correction terms (under the alternative) shows that the time taken to recover one half of a one standard deviation shock varies between five and twenty years, whereas the time taken to recover one half of a large shock varies between just 4 to 18 months. This clearly implies that data periods dominated by extreme volatility may display substantial mean reversion of the price-dividend relationship. By contrast this relationship may well look like a unit root when the underlying shocks take on smaller values.

Keywords: Unit roots, globally stationary cointegrating processes, nonlinear exponential smooth transition autoregressive error correction models, Monte Carlo simulations, prices and dividends

JEL Classification: C12, C13, C32

Suggested Citation

Kapetanios, George and Shin, Yongcheol and Snell, Andy, Testing for Cointegration in Nonlinear Star Error Correction Models (July 2003). U of London Queen Mary Economics Working Paper No. 497, Available at SSRN: https://ssrn.com/abstract=428602 or http://dx.doi.org/10.2139/ssrn.428602

George Kapetanios (Contact Author)

King's College, London ( email )

30 Aldwych
London, WC2B 4BG
United Kingdom
+44 20 78484951 (Phone)

Yongcheol Shin

Independent

Andy Snell

University of Edinburgh - Economics ( email )

50 George Square
Edinburgh, EH8 9JY
United Kingdom

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