ECONOMETRÍA FINANCIERA

Número de Regímenes

Tomado de Humala (2005). “Modelling interest rate pass-through with endogenous switching regimes in
Argentina”. PhD Thesis.

The initial step is to determine if there is indeed need for specifying at least two regimes
as an alternative to a single-regime (linear) model. Standard specification tests based on
likelihood ratios are not applicable because of the well-known problem of presence of
nuisance parameters under the null of linearity.1 Instead, empirical applications of
Markov switching models take a number of procedures to search for evidence of
nonlinearities. There is no widespread consensus upon which method to use for testing
the suitability of specifying a second regime though.

The econometric discussion about testing alternative nested models could be found in
Hansen (1992), Garcia (1998), Garcia and Perron (1996), and others. In this type of
testing, the null hypothesis of a linear model is confronted against the alternative of a
non-linear, Markov switching, model. Thus, the restricted version of the nonlinear
model is the linear model.

In his original contribution of Markov switching models to time series macroeconomics,

Hamilton (1988) spotted the problem of presence of nuisance parameters under the null
hypothesis. Still, Hansen (1992) treated it in detail. He proposed a standardized
likelihood ratio test for which he estimated upper bounds. The inapplicability of
hypothesis testing, such as the likelihood ratio (LR) test, arises because it does not meet
the standard conditions for testing. The first condition, that the likelihood surface must
be locally quadratic is usually violated if there are some (nuisance) parameters that are
unidentified under the null hypothesis. That is the case of the transition probabilities of
the regime-switching model under the null of linearity; the likelihood function becomes
flat with respect to the nuisance parameters at the optimum. The second condition, that
the score must have a positive variance is also violated when the null hypothesis yields
a local optimum or inflection point (with respect to the nuisance parameters).

1
See Hansen (1992) for a discussion on this.
Hansen (1992) avoids these problems by taking an approach that works directly with the
likelihood surface as an empirical process of the unknown parameters. He derives a
bound for the asymptotic distribution of a standardized LR statistics (but not asymptotic
values).2 Nonetheless, he recognizes that having only a bound for the statistics can lead
to under-rejection of a false null (loss in effective power of the test). Therefore, the test
should only be used when it is feasible that the conventional assumptions are invalid.

Hansen (1992) also recognizes that his test is highly demanding in computational terms.
This last characteristic has indeed prevented a much more extended use of the test. 3 A
recent example of its application is found in Boinet, Napolitano, and Spagnolo (2002),
who applied the test for a two-state Markov switching model of devaluation
expectations. Alternatively, Gray (1996) recognizes that he did not adjust the χ2
distribution for the likelihood ratio test to account for the presence of nuisance
parameters (the Hansen’s test) but relied in the empirical large difference in the log-
likelihood values he had obtained. Erlandsson (2002) points out that the Hansen’s test
would be hard to apply to a N-state Markov switching model, so he uses instead a
bootstrapping technique to approximate the distribution of the LR statistic (although this
method is itself also quite computationally demanding).

Hamilton (1988) in his application to the term structure of interest rate argues that the
Lagrange multiplier test is immune to the problem of nuisance parameters under the null
of linearity. All the same, Hamilton (1989) in his application to business cycle did not
attempt a formal hypothesis test to support his Markov switching model against the null
of a linear autoregressive model. He favoured his proposed model based on the better
description it offered of the dataset under study. Later on, Engel and Hamilton (1990)
offered an alternative solution to sidestep the problem of nuisance parameters by testing
against a more general null hypothesis that includes them but one that makes regimes
not persistent.4 Then, they rely on standard distribution theory and use a Wald test and a
LR test. Frömmel, MacDonald, and Menkhoff (2002), and Martínez (2002), for
instance, have used empirically these approximate tests of no switching.

2
Garcia (1998) derives analytically the asymptotic null distribution of the likelihood ratio test for a
number of two-regime Markov switching models. However, since this distribution is conditional on the
data and parameters, generic tabulation is not possible (Krolzig (1997)).
3
Gray (1996) points out that the procedure involves optimization over a grid of the nuisance parameters,
which is computationally demanding unless the model is quite simple or the grid is coarse.
4
That is, the probability of regime st is independent of st-1.
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….
Alternatively, then, non-nested hypothesis testing could be used to search for evidence
of neglected nonlinearity. That is, a number of portmanteau-type nonlinearity tests could
be applied to detect Markov switching dynamics. 5 These tests are constructed without a
specific nonlinear parametric alternative. Psaradakis and Spagnolo (2002) show, that in
general, these tests have good power features for rejecting a false null of linearity in
time series generated by Markov switching models. Nonetheless, results from these tests
will not provide definitive evidence in favour of Markov switching models. That is
because a rejection of the null of linearity could be due to a number of different features
of the data, such as nonlinearities other than Markov regime switching or conditional
heteroskedasticity.

Instead, another type of non-nested test is used here to complement, rather than replace,
the Hansen test. Garcia and Perron (1996) suggest estimating the model with the larger
number of regimes and run the so-called J-test for non-nested models. It uses a t-test for
the parameter on the estimated value of the endogenous using the model with the
highest number of regimes in an equation that also have that value from the alternative
model to explain the endogenous variable.6 They also use two other tests that rely on
giving a range of values to the nuisance parameters under the alternative hypothesis
(thus avoiding the need for estimating them): the Davies’ test and the Gallant’s test.7
Still, on their application to real interest rates and inflation rates, they find contradictory
results from these three tests, deciding upon two- or three-state switching models. They
favour the three-state model because the interpretation of it is richer and more appealing
from an economic perspective.

5
Among them, for instance, RESET-type tests, the Tsay test, the neural network test. See Psaradakis and
Spagnolo (2002) for a description of these tests. They have used Monte Carlo simulations to examine the
performance of these tests to detect Markov switching autoregressive models.
6
They use an equation of the form yt = ( 1 - d ) ft ( b ) + d gt + ut and apply a t-test on the parameter δ.
Where ft(β) is the estimated endogenous from the restricted model and gt is from the unrestricted model.
7
See Garcia and Perron (1996), and the references therein, for a detailed description of these two tests.