Simon van Norden

Regime switching in stock market returns

In this paper, we use an extension of Hamiltons (1989) Markov switching techniques to describe and analyze stock market returns. Using new tests, we find very strong evidence of switching behaviour. A major innovation of our work is to use a multivariate specification which allows us to examine whether the price-dividend ratio has marginal predictive power for stock market returns after accounting for state-dependent switching. We find strong evidence of predictability. The response of returns to the past price-dividend ratio is strongly asymmetric - about four times larger in the low-return state than in the high-return state. A second innovation in our work is to allow the probability of transitions from one regime to another to depend on economic variables.

Terms of trade and real exchange rates: the Canadian evidence

Abstract This paper presents empirical evidence linking the Canada-US real exchange rate with the terms of trade. Using recently developed econometric methods for nondashstationary data we find that the real exchange rate is cointegrated with terms-of-trade variables, and that causality runs from the terms of trade to the exchange rate. We then construct a simple exchange rate equation that satisfies several specification tests and performs better than a random walk in post-sample forecasting experiments. The results suggest that much of the variation in the real exchange rate is attributable to movements in the terms of trade and that the influence of monetary factors is secondary.

Regime switching as a test for exchange rate bubbles

This paper develops a new test for speculative bubbles, which is applied to data for the Japanese yen, the German mark and the Canadian dollar exchange rates from 1977 to 1991. The test assumes that bubbles display aparticular kind of regime-switching behaviour, which is shown to imply coefficient restrictions on a simple switching-regression model of exchange rate innovations. Test results are sensitive to the specification of exchange rate fundamentals and other factors. Evidence most consistent with the bubble hypothesis is found using an overshooting model of the Canadian dollar and a PPP model of the Japanese yen.

The Predictability of Stock Market Regime: Evidence from the Toronto Stock Exchange

Are stock market crashes and rallies related to deviations from the apparent fundamental share price? Using a switching-regression framework, the authors test whether apparent deviations help to predict the regime from which the next periods stock market return is drawn and the magnitude of returns in that regime. They find that the probability of a collapse rises before most actual crashes. Likelihood ratio tests confirm that regime switches are influenced by apparent deviations. Copyright 1993 by MIT Press.

Avoiding the Pitfalls: Can Regime-Switching Tests Reliably Detect Bubbles?

Our paper uses simulation methods to examine the size and power of regime-switching tests for bubbles. We find that even with several hundred observations, the tests show sometimes considerable size distortion. This distortion makes the tests conservative; they understate the significance of the evidence of bubbles. Despite this, the tests display considerable power to detect bubbles even when using the conservative asymptotic critical values. We also find that the frequency with which bubbles collapse has an important influence on the tests power. An application to monthly Canadian and American stock-price data provides mixed evidence of bubbles.

Exchange Rates and Oil Prices

The paper documents a robust and interesting relationship between the real domestic price of oil and real effective exchange rates for Germany, Japan and the United States. It also offers an explanation of why the real oil price captures exogenous terms-of-trade shocks, and why such shocks could be the most important factor determining real exchange rates in the long run. Copyright 1998 by Blackwell Publishing Ltd.

Fads or bubbles

Abstract. This paper tests between fads and bubbles using a switching regression to distinguish between competing models. Two main features of the bubbles model distinguish it from the fads model. First, the bubbles model implies that returns are drawn from regimes which differ in the way returns vary with deviations from fundamental prices. Second, the bubbles model implies that deviations from fundamental price will help predict regime switches. Using US data for 1926–89, we find evidence which is consistent with the fads model even when we allow for variation in expected dividend growth rates and expected discount rates. However, the restrictions which the fads model implies for a more general switching-regression specification are rejected. The rejections point in the direction of the bubbles model, although not all of the implications of the bubbles model are supported by the data.

Analytical Derivatives for Markov Switching Models

This paper presents analytical gradients for a broad class of regime-switching models with Markovian state-transition probabilities. Such models are usually estimated by maximum likelihood methods, which require the derivatives of the likelihood function with respect to the parameter vector. These gradients are usually calculated by means of numerical techniques. The paper shows that analytical gradients considerably speed up maximum-likelihood estimation.

Regime-Switching Models: A Guide to the Bank of Canada Gauss Procedures

This paper is a users guide to a set of Gauss procedures developed at the Bank of Canada for estimating regime-switching models. The procedures can estimate relatively quickly a wide variety of switching models and so should prove useful to the applied researcher. Sample program listings are included.