Likelihood Ratio Based Tests for Markov Regime Switching

Zhongjun Qu and Fan Zhuo ()
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Fan Zhuo: Boston University

No wp2015-003, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: Markov regime switching models are widely considered in economics and finance. Although there have been persistent interests (see e.g., Hansen, 1992, Garcia, 1998, and Cho and White, 2007), the asymptotic distributions of likelihood ratio based tests have remained unknown. This paper considers such tests and establishes their asymptotic distributions in the context of non- linear models allowing for multiple switching parameters. The analysis simultaneously addresses three difficulties: (i) some nuisance parameters are unidentified under the null hypothesis, (ii) the null hypothesis yields a local optimum, and (iii) conditional regime probabilities follow stochastic processes that can only be represented recursively. Addressing these issues permits substantial power gains in empirically relevant situations. Besides obtaining the tests' asymptotic distributions, this paper also obtains four sets of results that can be of independent interest: (1) a characterization of conditional regime probabilities and their high order derivatives with respect to the model's parameters, (2) a high order approximation to the log likelihood ratio permitting multiple switching parameters, (3) a refinement to the asymptotic distribution, and (4) a unified algorithm for simulating the critical values. For models that are linear under the null hypothesis, the elements needed for the algorithm can all be computed analytically. The above results also shed light on why some bootstrap procedures can be inconsistent and why standard information criteria, such as the Bayesian information criterion (BIC), can be sensitive to the hypothesis and the model's structure. When applied to the US quarterly real GDP growth rates, the methods suggest fairly strong evidence favoring the regime switching specification, which holds consistently over a range of sample periods.

Keywords: Hypothesis testing; likelihood ratio; Markov switching; nonlinearity (search for similar items in EconPapers)
JEL-codes: C12 C22 E32 (search for similar items in EconPapers)
Date: 2015-10
New Economics Papers: this item is included in nep-dge, nep-ecm, nep-ets, nep-for, nep-mac and nep-ore
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Journal Article: Likelihood Ratio-Based Tests for Markov Regime Switching (2021)
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