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Stock market bubbles, inflation and investment risk

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  • Kaliva, Kasimir
  • Koskinen, Lasse

Abstract

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.

Suggested Citation

  • Kaliva, Kasimir & Koskinen, Lasse, 2008. "Stock market bubbles, inflation and investment risk," International Review of Financial Analysis, Elsevier, vol. 17(3), pages 592-603, June.
    • Handle: RePEc:eee:finana:v:17:y:2008:i:3:p:592-603
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    3. Lof, Matthijs, 2010. "Heterogeneity in Stock Pricing: A STAR Model with Multivariate Transition Functions," MPRA Paper 30520, University Library of Munich, Germany.
    4. Chen, Mei-Ping & Lin, Yu-Hui & Tseng, Chun-Yao & Chen, Wen-Yi, 2015. "Bubbles in health care: Evidence from the U.S., U.K., and German stock markets," The North American Journal of Economics and Finance, Elsevier, vol. 31(C), pages 193-205.
    5. Zongjun Wang & Gongkhonkwa Rujira, 2013. "The Dynamic Relationship of Stock Indexes on Interbank Money Market Rates: Evidence from Thailand," International Journal of Economics and Financial Issues, Econjournals, vol. 3(4), pages 827-843.

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