Detecting Asset Price Bubbles with Time-Series Methods

• Activity Number: 588
• Type: Topic Contributed
• Date/Time: Wednesday, August 7, 2013 : 2:00 PM to 3:50 PM
• Sponsor: Business and Economic Statistics Section
• Author(s): Katja Taipalus*+
• Companies: Bank of Finland
• Keywords: indicator ; unit-root ; asset prices ; bubbles

Abstract

To promote the financial stability, there is a need for an early warning system to signal the formation of asset price misalignments. 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. Similarly well the methods are able to work with housing market data.