Speculative Behaviour, Regime-Switching and Stock Market Crashes
Bank of Canada Working Paper 96-13
60 Pages Posted: 11 Feb 1998
Date Written: October 1996
This paper uses regime-switching econometrics to study stock market crashes and to explore the ability of two very different economic explanations to account for historical crashes. The first explanation is based on historical accounts of "manias and panics." Its key features are that "overvaluation" increases the probability and expected size of a crash. Using U.S. data for 1926-89, we find considerable support for this model's predictions. The second explanation is based on switches in fundamentals. Simulations show that switching fundamentals can cause markets to mimic speculative behaviour. However, switches in fundamentals do not coincide with most stock market crashes.
JEL Classification: E44
Suggested Citation: Suggested Citation