Cointegration Tests Under Multiple Regime Shifts: An Application to the Stock Price-Dividend Relationship

We examine the properties of several residual-based cointegration tests when long run parameters are subject to multiple shifts driven by an unobservable Markov process. Unlike earlier work, which considered one-o¤ deterministic breaks, our approach has the advantage of allowing for an unspeci…ed number of stochastic breaks. We illustrate this issue by exploring the possibility of Markov switching cointegration in the stock-price dividend relationship and showing that this case is empirically relevant. Our subsequent Monte Carlo analysis reveals that standard cointegration tests are generally reliable, their performance often being robust for a number of plausible regime shift parameterizations. Key Words: Present value model; Cointegration tests; Markov switching. JEL Classi…cation: C32; G12; E44 Corresponding author. Address: UNIDE and Department of Quantitative Methods, ISCTE-LUI, Business School, Av. das Forças Armadas, 1649-026 Lisbon, Portugal. E-mail: [email protected]. Tel: + 351 21 7903439. Fax: + 351 21 7903941. yFinancial support under grant PTDC/ECO/68367/2006 from the Fundação para a Ciência e Tecnologia is gratefully acknowledged. We thank Stephen Hall, Zacharias Psaradakis, Yongcheol Shin, Ron Smith, and Martin Sola for helpful comments and suggestions.