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A Three-Regime Model of Speculative Behaviour: Modelling the Evolution of Bubbles in the S&P 500 Composite Index

  • Chris Brooks

    ()

    (ICMA Centre, University of Reading)

  • Apostolos Katsaris

    ()

    (ICMA Centre, University of Reading)

In this paper we examine whether a three-regime model that allows for dormant, explosive and collapsing speculative behaviour can explain the dynamics of the S&P 500 Composite Index for the period 1888-2001. We extend existing two-regime models of speculative behaviour by including a third regime that allows for a bubble to grow at a steady growth rate, and examine whether other variables, beyond the deviation of actual prices from fundamental values can help predict the level and the generating state of returns. We propose abnormal volume as an indicator of the probable time of the bubble collapse and thus include abnormal volume in the state and the classifying equations of the surviving regime in the explosive state. We show that abnormal volume is a significant predictor and classifier of returns. Furthermore, we find that the spread of the 6-month average actual returns above the 6-month average fundamental returns can help predict when a bubble will enter the explosive state. Finally, we examine the financial usefulness of the three-regime model by studying the risk-adjusted profits of a trading rule formed using inferences from it. Use of the three-regime model trading rule leads to higher risk adjusted returns and end of period wealth than those obtained from employing existing models or a buy and hold strategy.

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File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2002-14.pdf
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Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2002-14.

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Length: 48 pages
Date of creation: Apr 2002
Date of revision:
Publication status: Published in Economic Journal 115:505, 2005, 767-797
Handle: RePEc:rdg:icmadp:icma-dp2002-14
Contact details of provider: Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA
Phone: +44 (0) 118 378 8226
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Web page: http://www.henley.reading.ac.uk/
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  1. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  2. Kenneth D. West, 1988. "Bubbles, Fads, and Stock Price Volatility Tests: A Partial Evaluation," NBER Working Papers 2574, National Bureau of Economic Research, Inc.
  3. Kenneth D. West, 1986. "A Specification Test for Speculative Bubbles," NBER Working Papers 2067, National Bureau of Economic Research, Inc.
  4. van Norden Simon & Vigfusson Robert, 1998. "Avoiding the Pitfalls: Can Regime-Switching Tests Reliably Detect Bubbles?," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 3(1), pages 1-24, April.
  5. Van Norden, S. & Schaller, H., 1996. "Speculative Behaviour, Regime-Switching and Stock Market Crashes," Working Papers 96-13, Bank of Canada.
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