Both authors from Northwestern University and National Bureau of Economic Research. The authors thank the National Science Foundation for its support of their research. They also thank Paul Kaplan for helpful discussions.
Asset Price Volatility, Bubbles, and Process Switching
Article first published online: 30 APR 2012
1986 The American Finance Association
The Journal of Finance
Volume 41, Issue 4, pages 831–842, September 1986
How to Cite
FLOOD, R. P. and HODRICK, R. J. (1986), Asset Price Volatility, Bubbles, and Process Switching. The Journal of Finance, 41: 831–842. doi: 10.1111/j.1540-6261.1986.tb04551.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
Evidence of excess volatilities of asset prices compared with those of market fundamentals is often attributed to speculative bubbles. This study demonstrates that bubbles could in theory lead to excess volatility, but it shows that certain variance bounds tests preclude bubbles as an explanation. The evidence ought to be attributed to model misspecification or inappropriate statistical tests. One important misspecification occurs if a researcher incorrectly specifies the time series properties of market fundamentals. A bubble-free example economy characterized by a potential switch in government policies produces asset prices that would appear, to an unwary researcher, to contain bubbles.