Identifying Speculative Bubbles with an Infinite Hidden Markov Model

2 Infinite Hidden Markov ModelThe infinite hidden Markov model is expressed asy t | s t = i, Θ, Y 1,t−1 ∼ f(y t | θ i , Y 1,t−1 ), (1)Pr(s t = i | s t−1 = j, S 1,t−2 , P, Y 1,t−1 ) = Pr(s t = i | s t−1 = j, P ) = π ji , (2)where i, j = 1, 2, · · · . y t is the data at time t and Y 1,t−1 = (y 1 , · · · , y t−1 ). s t is the regimeindicator at time t and S 1,t−2 = (s 1 , · · · , s t−2 ). Θ = (θ 1 , θ 2 , · · · ) is the collection of parameterθ i ’s, which characterize each regime. P is an infinite dimensional transition matrix with π ji onits jth row and ith column. 6 (1) shows that the conditional density of y t depends on s t andthe past information Y 1,t−1 . (2) implies that the dynamic of s t only depends on s t−1 .A finite hidden Markov model (HMM) with K regimes, for instance the two-regime Markovswitchingmodel of HPS (K = 2), is nested in the iHMM by assuming K π ji = 1 for j∑=1, · · · , K, and the initial regime s 1 ∈ {1, · · · , K}. In addition, the periodically collapsingprocess of Evans (1991) and the locally explosive process of Phillips et al. (2011b) can becaptured by a three-regime HMM.In order to identify exuberant dynamics, this paper assumes (1) to have a form as of theaugmented Dickey-Fuller (ADF) test:i=1f(∆y t | θ st , Y 1,t−1 ) ∼ N(ϕ st ,0 + β st y t−1 + ϕ st, 1∆y t−1 + · · · + ∆ϕ st, qy t−q , σ 2 s t), (3)where q is the lag order and θ st = (ϕ ′ s t, σ st ) by construction with ϕ st = (ϕ st ,0, β st , ϕ st, 1, · · · , ϕ st ,q).Notice that we model ∆y t instead of y t . The existence of explosive behaviors is determined bythe coefficient of y t−1 , namely β st . A random walk process implies β st = 0 in an ADF test. Inthis paper, a positive β st shows that y t is explosive at time t.The Bayesian approach is applied in estimation to deal with infinite dimensionality. Twoparallel hierarchical priors, one governing Θ and the other governing P , are introduced as6 ∑By definition, π ji ≥ 0 for all j, i = 1, 2, · · · and ∞ π ji = 1 for all j = 1, 2, · · · .i=16