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Stock market bubbles, inflation and investment risk

  • Kaliva, Kasimir
  • Koskinen, Lasse
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    This paper proposes an autoregressive regime-switching model of stock price dynamics in which the process creates pricing bubbles in one regime while error-correction prevails in the other. In the bubble regime the stock price depends negatively on inflation. In the error-correction regime it depends on the price-dividend ratio. We find that the probability of regime-switch depends on exogenous inflation and lagged price. The model is consistent with Shleifer and Vishny's theoretical noise trader and arbitrageur model and Modigliani's inflation illusion phenomenon. The results emphasize the importance of inflation and the price-dividend ratio when assessing investment risk.

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    Article provided by Elsevier in its journal International Review of Financial Analysis.

    Volume (Year): 17 (2008)
    Issue (Month): 3 (June)
    Pages: 592-603

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    Handle: RePEc:eee:finana:v:17:y:2008:i:3:p:592-603
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    1. Robert J. Shiller, 1997. "Why Do People Dislike Inflation?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 13-70 National Bureau of Economic Research, Inc.
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    8. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
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    11. Black, Fischer, 1986. " Noise," Journal of Finance, American Finance Association, vol. 41(3), pages 529-43, July.
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    13. Hess, Martin K., 2003. "What drives Markov regime-switching behavior of stock markets? The Swiss case," International Review of Financial Analysis, Elsevier, vol. 12(5), pages 527-543.
    14. Donald W.K. Andrews & Werner Ploberger, 1992. "Optimal Tests When a Nuisance Parameter Is Present Only Under the Alternative," Cowles Foundation Discussion Papers 1015, Cowles Foundation for Research in Economics, Yale University.
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    17. Anders Rahbek & Neil Shephard, 2001. "Autoregressive conditional root model," Economics Papers 2002-W7, Economics Group, Nuffield College, University of Oxford, revised 01 Feb 2002.
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