1. What are the contributions in this paper?
This paper discriminates between three potential sources of instability in parameter estimates of stock return models.. The authors then use Goldfeld and Quandt 's ( 1976 ) D-method of switching regression, deterministic switching based on time, to study the structural change in their model.. The authors examine two eight-year sample periods and find that both contain a regime shift driven by an abrupt change in volatility.. Mehta and Beranek ( 1982 ), for example, use switching regressions to study changes in a stock 's volatility ( as measured by the Capital Asset Pricing Model 's /3 coefficient ) across different regimes.. French, Schwert, and Stambaugh ( 1987 ) study the link between expected stock returns and volatility, reporting that the conditional variance of stock returns is a significant determinant of expected stock returns.. This paper studies three potential sources of instability in parameter estimates of stock return models.. This method not only identifies switch points and estimates the model coefficients, but also provides a parameter 0 * which measures the abruptness of the change.. This paper applies the Goldfeld-Quandt method to a model of stock returns with three potential sources of parameter instability.. The authors study two eight-year sample periods from 1971 to 1986 and find that both contain a regime shift driven by an abrupt change in volatility.. The paper is organized as follows.. Bollerslev ( 1987 ) and Baillie and Bollerslev ( 1989 ) show that conditional heteroscedasticity characterizes much financial data ; this suggests that if investors are not risk-neutral and if shocks to the volatility-generating function are permanent or decay only very slowly, the process generating mean returns might also change.. Goldfeld and Quandt 's ( 1976 ) D-method of switching regression, deterministic switching based on time, seems especially promising.. This suggests that regime shifts resulting from changes in volatility are likely to be abrupt.. Since Kane and Unal ( 1988 ) interpret switches as evidence of movements in omitted variables, the authors control for this potential source of structural instability.. If the rate of compensation is positive, P is greater than P ' t t ' Since equation ( 2 ) holds at any t, the authors can also write Substituting ( 2 ) and ( 3 ) into ( 1 ) yields Taking natural logs and rearranging obtains Dt Dt-l Rt = [ log ( P ; ) l~g ( P ; -~ ) + dtl + ( i & lci, t ) i & l Ci, t-l. ( 5 ) Dt Dt-l
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