Unit Root Tests With Markov-Switching

Qin Xiao and Gee Kwang Randolph Tan

No 95, Computing in Economics and Finance 2005 from Society for Computational Economics

Abstract: Diba and Grossman (1988) and Hamilton and Whiteman (1985) recommended unit root tests for rational bubbles. They argued that if stock prices are not more explosive than dividends, then it can be concluded that rational bubbles are not present. Evans (1991) demonstrated that these tests will fail to detect the class of rational bubbles which collapse periodically. When such bubbles are present, stock prices will not appear to be more explosive than the dividends on the basis of these tests, even though the bubbles are substantial in magnitude and volatility. Hall et al. (1999) show that the power of unit root test can be improved substantially when the underlying process of the sample observations is allowed to follow a first-order Markov process. Our paper applies unit root tests to the property prices of Hong Kong and Seoul, allowing for the data generating process to follow a three states Markov chain. The null hypothesis of unit root is tested against the explosive bubble or stable alternative. Simulation studies are used to generate the critical values for the one-sided test. The time series used in the tests are the monthly price and rent indices of Seoul’s housing (1986:1 to 2003:6) and Hong Kong’s retail premise (1980:12 to 2003:1). The investigations show that only one state appears to be highly likely in all series under investigation and the switching unit root procedure failed to find explosive bubbles in both prices.

Keywords: unit root; bootstrap; Markov-Switching (search for similar items in EconPapers)
JEL-codes: C52 (search for similar items in EconPapers)
Date: 2005-11-11
New Economics Papers: this item is included in nep-ets
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http://repec.org/sce2005/up.13013.1106542016.pdf (application/pdf)

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Working Paper: Unit Root Tests with Markov-Switching (2004)
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