Avoiding the Pitfalls: Can Regime-Switching Tests Detect Bubbles?

Posted: 6 Jan 1998

See all articles by Simon van Norden

Simon van Norden

HEC Montreal - Department of Finance; CIRANO; University of Montreal - Center for Interuniversity Research in Econometrics

Robert J. Vigfusson

Board of Governors of the Federal Reserve System

Date Written: August 1996

Abstract

Work on testing for bubbles has caused much debate, much of which has focussed on methodology. Monte Carlo simulations reported in Evans (1991) showed that standard tests for unit roots and cointegration frequently reject the presence of bubbles even when such bubbles are present by construction. Evans referred to this problem as the pitfall of testing for bubbles. Since Evans' note, new tests for rational speculative bubbles that rely on regime-switching have been proposed. Van Norden and Schaller (1993) and van Norden (1996) use a switching regression to look for a time-varying relationship between returns and deviations from an approximate fundamental price. Hall and Sola (1993) and Funke, Hall and Sola (1994) test whether asset prices seem to switch between explosive growth and stationary behaviour. Our paper reports on Monte Carlo experiments using Evans' data-generating process to gauge the performance of these two kinds of regime-switching tests. The experiments rely heavily on certain new, fast and robust programs developed at the Bank of Canada for the estimation of switching regression models that make Monte Carlo studies of such estimators practical. We find that for some (but not all) parameter values, regime-switching tests have a significant amount of power to detect periodically collapsing bubbles. We also compare and contrast the performance of the two different regime-switching tests. FRENCH VERSION La mise au point de tests de detection des bulles speculatives a occasionne bien des debats, principalement sur des points de methodologie. Evans (1991) a demontre, au moyen de simulations de Monte-Carlo, que la presence de bulles est frequemment rejetee par les tests standard de racine unitaire et de cointegration meme quand des bulles ont ete incorporees a la construction des donnees. Ce probleme constitue, a ses yeux, la pierre d'achoppement de ce type de tests de detection des bulles. Depuis la parution de l'article d'Evans, on a propose de nouveaux tests de detection des bulles speculatives rationnelles qui s'appuient sur un changement de regime. van Norden et Schaller (1993) et van Norden (1996) ont eu recours a une regression avec changement de regime afin d'etablir s'il existe une relation, variable dans le temps, entre les rendements et les ecarts observes par rapport a un prix fondamental approximatif. De leur cote, Hall et Sola (1993) et Funke, Hall et Sola (1994) ont cherche a determiner si le prix des actifs oscille entre une croissance explosive et un etat stationnaire. Dans la presente etude, les auteurs evaluent la puissance de ces deux types de tests au moyen de simulations de Monte-Carlo; ils emploient pour cela le processus generateur de donnees qu'utilise Evans. Leurs simulations font appel aux nouveaux programmes rapides et eprouves mis au point a la Banque du Canada pour l'estimation des modeles de regression avec changement de regime, lesquels rendent possible l'etude de tels estimateurs au moyen de simulations. Les auteurs constatent que pour certaines valeurs parametriques (mais pas pour toutes), les tests de regression avec changement de regime sont suffisamment puissants pour deceler les bulles qui s'effondrent periodiquement. Enfin, ils comparent la performance des deux tests afin d'en faire ressortir les similarites et les ifferences.

JEL Classification: C15, C22, C32

Suggested Citation

van Norden, Simon and Vigfusson, Robert John, Avoiding the Pitfalls: Can Regime-Switching Tests Detect Bubbles? (August 1996). Available at SSRN: https://ssrn.com/abstract=50942

Simon Van Norden (Contact Author)

HEC Montreal - Department of Finance ( email )

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HOME PAGE: http://svannorden.org

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University of Montreal - Center for Interuniversity Research in Econometrics ( email )

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Robert John Vigfusson

Board of Governors of the Federal Reserve System ( email )

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Washington, DC 20551
United States

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