LM Cointegration Tests Allowing for an Unknown Number of Breaks: Implications for the Forward Rate Unbiasedness Hypothesis

• Activity Number: 365
• Type: Contributed
• Date/Time: Tuesday, August 2, 2016 : 10:30 AM to 12:20 PM
• Sponsor: Business and Economic Statistics Section
• Author(s): Dong-Yop Oh and Hyejin Lee*
• Companies: The University of Texas Rio Grande Valley and The University of Texas Rio Grande Valley
• Keywords: LM cointegration test ; Structural changes ; Forward rate unbiased hypothesis

Abstract

This study extends the Lagrange multiplier (LM) cointegration test developed by Westerlund and Edgerton (WE; 2006) by allowing for an unknown number of breaks. Monte Carlo simulations provide two main results. First, a loss of power in the LM cointegration tests is detected when potential breaks are ignored. Second, the modified testing procedures do not affect to the asymptotic distribution and major properties of the tests of WE under the null, but reasonably increase their testing power in presence of multiple breaks. We also provide empirical applications of the proposed tests for the forward rate unbiasedness hypothesis (FRUH). The results reveal that the FRUH does hold when the effects of the multiple structural breaks are taken into account.