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A Markov Regime-Switching Model with Time-Varying Transition Probabilities for Identifying Asset Price Bubbles

Author

Listed:
  • Matthew L. Higgins
  • Frank Ofori-Acheampong

Abstract

In this paper, a Markov regime-switching model with time-varying transition probabilities is developed to identify asset price bubbles in the S&P 500 index. The model nests two different methodologies; a state-dependent regime-switching model and a Markov regime-switching model. Three bubble regimes are identified; dormant, explosive, and collapsing. Time-varying transition probabilities are specified for each of the nine possible transitions in the Markov regime-switching model. Estimation of the model is done using conditional maximum likelihood with the Hamilton filter. Results show that transition probabilities depend significantly on trading volume and relative size of the bubble. Overall, the model works well in detecting multiple bubbles in the S&P 500 between January 1888 and May 2010. Explosive bubbles tend to immediately precede recession periods, while collapsing bubbles tend to coincide with recession periods.

Suggested Citation

  • Matthew L. Higgins & Frank Ofori-Acheampong, 2018. "A Markov Regime-Switching Model with Time-Varying Transition Probabilities for Identifying Asset Price Bubbles," International Journal of Economics and Finance, Canadian Center of Science and Education, vol. 10(4), pages 1-14, April.
    • Handle: RePEc:ibn:ijefaa:v:10:y:2018:i:4:p:1-14
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    References listed on IDEAS

    as
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    3. 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.
    4. van Norden, Simon & Schaller, Huntley, 1993. "The Predictability of Stock Market Regime: Evidence from the Toronto Stock Exchange," The Review of Economics and Statistics, MIT Press, vol. 75(3), pages 505-510, August.
    5. Andras Fulop & Jun Yu, 2017. "Bayesian Analysis of Bubbles in Asset Prices," Econometrics, MDPI, vol. 5(4), pages 1-23, October.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    asset price bubble; Markov regime-switching; recession; S&P 500 index; time-varying transition probability;
    All these keywords.

    JEL classification:

    • R00 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - General - - - General
    • Z0 - Other Special Topics - - General

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