IDEAS home Printed from https://ideas.repec.org/p/red/sed004/374.html
   My bibliography  Save this paper

Optimal test for Markov switching

Author

Listed:
  • Marine Carrasco
  • Liang Hu

Abstract

We propose a new test for the stability of parameters in a Markov switching model where regime changes are driven by an unobservable Markov chain. Testing in this context is more challenging than testing in structural change and threshold models because, besides the presence of nuisance parameters that are not identified under the null hypothesis, there is the additional difficulty due to the singularity of the information matrix under the null. We derive a class of information matrix-type tests and show that they are equivalent to the likelihood ratio test. Hence, our tests are asymptotically optimal. Besides their optimality properties, these tests are more general than the competing tests proposed by Garcia (1998) and Hansen (1992). Indeed, the underlying Markov chain driving the regime changes may have a finite or continuous state space, as long as it is exogenous. It is not restricted to linear models either. Therefore, our technique applies for instance to testing stability in random coefficient GARCH models. We use this test to investigate the presence of rational collapsing bubbles in stock markets. There is bubble if the stock price is disconnected from the market fundamental value. We regress the stock price on dividends and use the residual as proxy for the bubble size. Using US data, we find that the residuals are stationary, which could be hastily interpreted as evidence against the presence of bubbles. However, our Markov switching test strongly rejects the linearity, suggesting that at least two regimes should be used to fit the data. Estimating a two-state Markov switching model (Hamilton, 1989) reveals that one regime has a unit root, while the other is mean reverting, which is consistent with periodically collapsing bubbles

Suggested Citation

  • Marine Carrasco & Liang Hu, 2004. "Optimal test for Markov switching," 2004 Meeting Papers 374, Society for Economic Dynamics.
  • Handle: RePEc:red:sed004:374
    as

    Download full text from publisher

    To our knowledge, this item is not available for download. To find whether it is available, there are three options:
    1. Check below whether another version of this item is available online.
    2. Check on the provider's web page whether it is in fact available.
    3. Perform a search for a similarly titled item that would be available.

    Other versions of this item:

    More about this item

    Keywords

    econometrics; speculative bubbles; Markov switching; test;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed004:374. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Christian Zimmermann (email available below). General contact details of provider: https://edirc.repec.org/data/sedddea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.