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

Author

Listed:
  • Chris Brooks

    () (ICMA Centre, University of Reading)

  • Apostolos Katsaris

    () (ICMA Centre, University of Reading)

Abstract

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.

Suggested Citation

  • Chris Brooks & Apostolos Katsaris, 2002. "A Three-Regime Model of Speculative Behaviour: Modelling the Evolution of Bubbles in the S&P 500 Composite Index," ICMA Centre Discussion Papers in Finance icma-dp2002-14, Henley Business School, Reading University.
  • Handle: RePEc:rdg:icmadp:icma-dp2002-14
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    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2002-14.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Simon van Norden & Huntley Schaller & ), 1995. "Speculative Behaviour, Regime-Switching, and Stock Market Crashes," Econometrics 9502003, EconWPA.
    3. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
    4. Kenneth D. West, 1987. "A Specification Test for Speculative Bubbles," The Quarterly Journal of Economics, Oxford University Press, vol. 102(3), pages 553-580.
    5. West, Kenneth D, 1988. " Bubbles, Fads and Stock Price Volatility Tests: A Partial Evaluation," Journal of Finance, American Finance Association, vol. 43(3), pages 639-656, July.
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    Citations

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    Cited by:

    1. Keith Anderson & Chris Brooks & Sotiris Tsolacos, 2009. "Testing for periodically collapsing rational speculative bubbles in US REITs," ICMA Centre Discussion Papers in Finance icma-dp2009-11, Henley Business School, Reading University.
    2. Anderson, Keith & Brooks, Chris & Katsaris, Apostolos, 2010. "Speculative bubbles in the S&P 500: Was the tech bubble confined to the tech sector?," Journal of Empirical Finance, Elsevier, vol. 17(3), pages 345-361, June.

    More about this item

    Keywords

    Stock market bubbles; fundamental values; dividends; regime switching; speculative bubble tests;

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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