A0154
Title: Model-based test for asset price bubbles
Authors: Robert Taylor - University of Essex (United Kingdom) [presenting]
Abstract: The purpose is to develop tests for asset price bubbles that are derived directly from the standard stock pricing equation commonly employed in the finance literature, whereby stock prices are determined by expectations of the future price, future dividends, and an unobserved component. The general solution to this equation shows that the price of an asset is the sum of a fundamental component and an explosive component that only takes non-zero values during bubble periods. While the current literature focuses almost exclusively on modeling asset prices as a single autoregressive process and testing the null of a unit root against the alternative of explosivity, this is not the model implied by finance theory. Instead, the solution is directly used to the asset price equation, and locally best invariant [LBI] motivated tests is constructed, designed to test the null that the innovations to the bubble component of the asset pricing equation have zero variance (and hence no bubble exists), against the alternative that these innovations have non-zero variance (and hence an asset price bubble exists). Recursive versions of the proposed test are also developed, and it is shown via simulation that these tests are significantly more powerful than the industry standard tests developed by a prior study.
