Scientific Monographs, Bank of Finland
Detecting asset price bubbles with time-series methods
Abstract: To promote the financial stability, there is a need for an
early warning system to signal the formation of asset price misalignments.
This research provides two novel methods to accomplish this task. Results
in this research shows that the conventional unit root tests in modified
forms can be used to construct early warning indicators for bubbles in
financial markets. More precisely, the conventional augmented Dickey-Fuller
unit root test is shown to provide a basis for two novel bubble indicators.
These new indicators are tested via MC simulations to analyze their ability
to signal emerging unit roots in time series and to compare their power
with standard stability and unit root tests. Simulation results concerning
these two new stability tests are promising: they seem to be more robust
and to have more power in the presence of changing persistence than the
standard stability and unit root tests. When these new tests are applied to
real US stock market data starting from 1871, they are able to signal most
of the consensus bubbles, defined as stock market booms for example by the
IMF, and they also flash warning signals far ahead of a crash. Also
encouraging are the results with these methods in practical applications
using equity prices in the UK, Finland and China as the methods seem to be
able to signal most of the consensus bubbles from the data. Finally, these
early warning indicators are applied to data for several housing markets.
In most of the cases the indicators seem to work relatively well,
indicating bubbles before the periods which, according to the consensus
literature, are seen as periods of sizeable upward or downward movements.
The scope of application of these early warning indicators could be wide.
They could be used eg to help determine the right timing for the start of a
monetary tightening cycle or for an increase in countercyclical capital
Keywords: asset prices; financial crises; bubbles; indicator; unit-root; (follow links to similar papers)
JEL-Codes: C15; G01; G12; (follow links to similar papers)
217 pages, November 15, 2012
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