CHANGE-POINT ANALYSIS OF ASSET PRICE BUBBLES WITH POWER-LAW HAZARD FUNCTION

Christopher Lynch and Benjamin Mestel ()
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Christopher Lynch: School of Mathematics & Statistics, The Open University, Milton Keynes, MK7 6AA, UK
Benjamin Mestel: School of Mathematics & Statistics, The Open University, Milton Keynes, MK7 6AA, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2019, vol. 22, issue 07, 1-24

Abstract: We present a methodology to identify change-points in financial markets where the governing regime shifts from a constant rate-of-return, i.e. normal growth, to a superexponential growth described by a power-law hazard rate. The latter regime corresponds, in our view, to financial bubbles driven by herding behavior of market participants. Assuming that the time series of log-price returns of a financial index can be modeled by arithmetic Brownian motion, with an additional jump process with power-law hazard function to approximate the superexponential growth, we derive a threshold value of the hazard-function control parameter, allowing us to decide in which regime the market is more likely to be at any given time. An analysis of the Standard & Poors 500 index over the last 60 years provides evidence that the methodology has merit in identifying when a period of herding behavior begins, and, perhaps more importantly, when it ends.

Keywords: Criticality; jump process; change point; financial bubble; power laws (search for similar items in EconPapers)
Date: 2019
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DOI: 10.1142/S021902491950033X

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