INTRINSIC BUBBLES AND REGIME-SWITCHING

Froot and Obstfeld (1991) allow for an intrinsic bubble in stock price s, using approximately a century of annual data for the US, in an atte mpt to model the widely documented deviations from the prices predicte d by present values or fundamentals, However they assume that the log of real dividends follows a constant random walk with drift over the w hole period. We show that this assumption is invalid, and that a Marko v-switching model is a more appropriate representation of dividends. W e then generalise the formulation of stock prices (including the intri nsic bubble) to allow for this, and show that regime-switching provide s a better explanation for stock prices than the bubble. We show that when allowance is made both for the bubble and for regime-switching in the dividend process, the incremental explanatory contribution of the bubble is low. (C) 1998 Elsevier Science B.V. All rights reserved.