JOURNAL OF APPLIED ECONOMETRICS, VOL. 11.

41-58 (1996)

TRANSIENT FADS AND THE CRASH OF '87

CHANG-JIN KIM
Department of Economics, Korea University, Seoul, 136-701 Korea, and Department of Economics, York University,
4700, Keele Street, North York, Ontario, Canada M3JIP3

MYUNG-JIG KIM
Department of Economics, Finance, and Legal Studies, Box 870224, University of Alabama, Tuscaloosa, AL 35487,
USA, and Department of Economics, Hanyang University, Seoul, 133 Korea

SUMMARY
Using a fad model with Markov-switching heteroscedasticity in both the fundamental and fad components
(UC-MS model), this paper examines the possibility that the 1987 stock market crash was an example of
a short-lived fad. While we usually think of fads as speculative bubbles, what the UC-MS model seems to
be picking up is unwarranted pessimism which the market exhibited with the OPEC oil shock and the '87
crash. Furthermore, the conditional variance implied by the UC-MS model captures most of the dynamics
in the GARCH specification of stock return volatility. Yet unlike the GARCH measure of volatility, the
UC-MS measure of volatility is consistent with volatility reverting to its normal level very quickly after
the crash.

1. INTRODUCTION
The October 1987 stock market crash was unusual in many ways. It was characterized by the
largest one-day drop in the history of major stock market indices since 1885, followed by a
dramatic jump in stock volatility. Yet, as demonstrated in Schwert (1990), volatility returned to
lower, normal levels more quickly than past experience would have predicted.
Other recent research confirms Schwert's (1990) finding. For example, Engle and Mustafa
(1992) show that the persistence of volatility was much weaker after the crash, suggesting a
temporary structural change in the persistence parameters of the conditional heteroscedasticity
(GARCH) implied by option prices. Friedman and Laibson (1989) also provide evidence that it
is not appropriate to use the same GARCH specification to describe the consequences of both
large and small shocks. These results suggest that the usual constant-parameter GARCH models
exhibit a poor statistical description of extremely large shocks such as those during the crash.
To give a better explanation of the behaviour of stock volatility after the crash, Engle and Lee
(1992) decompose stock volatility into trend and transitory components and compare the results
to that obtained from a usual GARCH model. Hamilton and Susmel (1993) consider the
possibility that the extremely large shocks during the 1987 crash came from one of several
different regimes, with transition between regimes governed by an unobserved Markov chain.
The Markov-switching ARCH (SWARCH) model they propose could provide a better
description of the 1987 stock market crash. They all find that persistence of stock return
volatility during and after the crash was smaller than that implied by a usual GARCH model.
This paper examines the possibility that the 1987 stock market crash was an example of
unusually large transitory shocks that are short-lived. In modelling stock returns to include a
transitory component, or fads, in stock prices, the paper employs a version of an unobserved
CCC 0883-7252/96/010041- 18
0 1996 by John Wiley & Sons, Ltd.

Received December 1993

Revised January 1995

42

C.-J. KIM AND M.-J. KIM

component model with Markov-switching heteroscedasticity (UC-MS model). This model can
capture some short-run dynamics that might otherwise not be captured by variance ratio tests
(see e.g. Poterba and Summers, 1988; Lo and MacKinlay, 1988; Kim et ul., 1991), by
autoregression test (see Fama and French, 1988), or by conventional unobserved component
models (see Clark, 1987; Watson, 1986). These models, which do not explicitly address the
importance of heteroscedasticity, may miss some important short-run dynamics of interest,
especially during the unusual periods such as the crash. This paper finds that highly persistent
fad components exist in stock prices, but their presence is only intermittent. For the period
January 1952 to December 1992, only two episodes of statistically significant transient fads are
identified: the 1987 crash and the 1973-4 OPEC recession.
This paper then examines the volatility of stock returns and its persistence as implied by the
UC-MS model, with special attention to the period just after the 1987 stock market crash. For
the sample period employed, the conditional variance from the UC-MS model captures most of
the dynamics in the GARCH specification of return volatility. Yet unlike the GARCH measure
of volatility which tends to decay rather slowly following large shocks, the UC-MS measure of
volatility is consistent with volatility reverting to its normal level very quickly after the crash.
Also, the decomposition of stock return volatility into trend and fad components based on the
UC-MS model is comparable to that of the Engle and Lee (1992) component model.
The rest of this paper is organized as follows. Section 2 motivates the model for stock returns
with transient fads in stock prices. Section 3 sets up the empirical model. A version of the
Markov-switching heteroscedasticity model proposed by Turner et ul. (1989) is employed and
extended to include fad components in stock prices within an unobserved-component model
framework. Section 4 discusses empirical results on the nature of the fad components, as well
as on the persistence in volatility of stock returns. Section 5 concludes the paper.
2. MOTIVATION FOR EMPIRICAL MODEL
Consider the following model by Summers (1986) and Poterba and Summers (1988), which is
often referred to as a fad model:

P , = P,* + z,
P,* = p, + P*,_,+ v,,
z, =

+(L)e,,

(1)

v , N ( 0 , a:,)
e,- N(O,

d,)

(2)
(3)

where P, is the natural log of stock price; P,* is the fundamental, which is assumed to evolve
slowly over time; and z, is a persistent but stationary component. In this case, the return, defined
as a log-differenced prices, is given by

y , = P , - P , - ] = p , + v , + (Z,-Z,-1)
(4)
When the transitory component z, has a root close (but not equal) to unity a given change in
price tends to be reversed over a long period of time by a predictable change in the opposite
direction. As the conventional view of asset markets states that the sequence of returns should
be serially random, the transitory component or the component of stock returns that can be
forecast might reasonably be labelled as a fad. De Long et al. (1990), for example, developed
a theory in which shocks to the z, component may be caused by the noisy traders
misperceptions. In the noise trader model, an important proportion of the market consists of
See Fama and French (1988) for a detailed discussion of the behaviour of long autocorrelations implied by such
models.

TRANSIENT FADS

43

noisy traders, i.e. investors who bid prices away from fundamentals, and changes in noisy
traders' price misperception can result in very large and persistent changes in prices. The
significance of the mean reversion in stock prices or the significance of the fad component
could be tested in principle by decomposing the stock price into the two components.
Several authors have proposed methods of decomposing a univariate series into permanent
and transitory components. For example, Nelson and Plosser (1982) match a model consisting
of permanent and temporary components to an autocorrelation function to get the relative size
of each component. Watson (1986) and Clark (1987) used unobserved component models to
decompose GNP series into two components. Campbell and Mankiw (1987), using parameters
of the low-order autoregressive ARMA representation of a series, estimate the effect of a shock
on long-run forecasts to assess the importance of the permanent or transitory component.
Recently, alternative methods have been employed to detect mean reversion and/or fads in
stock prices. For example, Poterba and Summers (1988), Lo and MacKinlay (1988), and Kim et
al. (1991) employed the variance-ratio methodology of Cochrane (1988), and Fama and French
(1988) used an autoregression test in analysing mean reversion in stock prices. These studies
report mixed evidence on the existence of mean reversion in stock prices.
In assessing the importance of the transitory component, none of the studies of mean
reversion in stock prices consider the possibility of extremely unusual, temporal deviations of
stock prices from a random walk component that last only a very brief period of time. The
October 1987 market crash could be one such case.2 Variance ratio tests, or other methods of
decomposition surveyed above, are likely to miss some important short-run dynamics in the
presence of transitory shocks of this kind. The objective of the paper is to assess the possibility
of such transitory shocks and to introduce an empirical model which can capture the important
short-run dynamics in stock prices that are likely to be missed by other models.
3. MODELLING STOCK RETURNS WITH TRANSIENT FADS (UC-MS MODEL)

To set the stage, consider the following empirical model for excess returns with Markovswitching heteroscedasticity proposed previously by Turner et al. (1989):
Yrx= pr + ut,

a:,

ur I S,- N(O,

(1 - S,)a,2+ s,a:

(51
(6)

where y,*is the excess return measured by log differences of stock prices adjusted for dividends
less risk-free interest, p, is the time-varying risk premium. S,is given by the two-state, firstorder Markov process with the following transition probabilities:

Pr[S,= 1 I S,-l
= 13 = pII and Pr [S,= 0 I S,-I = 01 = poo

(7)

This model can be regarded as an alternative to a popular specification of changing volatility,

namely, the ARCH-class models. For example, the GARCH(1,l) model specifies the
conditional variance as:
u,

I Vr-1 - N(O?h,)

2
h,= a,+ a,u,-,
+ a,h,-,

(8)

where q,-,refers to the available information up to time t - 1. As the empirical results in the next
section shows, the two-state Markov-switching model of Turner et al. (1989) does not seem to
'Or the mean reversion in stock price may be seasonal. Jegadeesh (1991), for example, argues the mean reversion in
stock prices is entirely concentrated in the month of January.

44

C.-J. KIM AND M.-J. KIM

capture enough variation in volatility when compared to the GARCH model, but it allows for
faster decay of volatility. Moreover, neither allows for the possibility of transitory shocks.
This paper proposes a model which allows for the possibility of fad components in the
Turner et al. model. For an AR(2) specification for the fad component z, and a constant mean p,
the expression for stock returns from the model in equations (1)-(4) can be rewritten in the
following state-space specification:
r

Recently, estimation of the unobserved component model of equations (9) and (10) with
heteroscedastic disturbances has been made possible by Harvey et al. (1992) and Kim (1993).
For example, Harvey et af. (1992) consider ARCH-type heteroscedasticity for e, and v, and
Kim (1993) considers Markov-switching heteroscedasticity for unobserved component models.
This paper follows Kim (1993) and Turner et al. (1989) in assuming Markov-switching
variances for the shocks.3 We therefore specify variances of the shocks in equations (8) and (9) in
the following way:
(1 1)
a:, = (1 - S,,)a,
+ Swra.Z1
a:, > u,

u:,= (1 - Se,)u&+ S,a,2,

a:, > u2,

(12)

where S,, and S,, are discrete-valued, unobserved first-order Markov-switching variables that
evolve independently of each other according to the following transition probabilities:

f i [ S u r = O l Sw,,-,=OI=p,,
fi[S,r=OIS,,r-,=OI=p,,

Pr[Su,=1 ) S u , , - l = 1 I = ~ u l
fi[Ser=1

(13)

ISe,t-l=1I=~eI

(14)

We assume that shocks to the fundamental and fad components are independent. Notice,
however, that there is no sufficient economic justification in this specification to uniquely
identify the fad and fundamental components, since an infinite number of different models of
the form (1)- (4) could exist which might describe the observed data equally well, depending on
the assumption one makes about the correlation between e, and v,. (Refer to Watson, 1986.)
Estimation of the above unobserved component model with Markov-switching heteroscedasticity
(UC-MS model) is described in Kim (1993) and reproduced in the Appendix. For more details on
the nature of approximations employed in the estimation of related models, readers are referred to
Kim (1993, 1994).
4. EMPIRICAL RESULTS
Data examined are the monthly S&P 500 index covering the 1951.1 to 1992.12 period. (Data are
constructed from the monthly closing prices, taken from Ibbotson Associates, 1993, SBBZ

Another motivation for introducing Markov-switching variables to the model is given by Cecchetti

et

al. (1990).

45

TRANSIENT FADS

Yearbook, Chicago.) We chose monthly data in order to make the implication of the transient
fads model comparable with the ones of the mean reversion literature such as Fama and French
(1988) and Poterba and Summers (1988). A finer frequency of the data could be employed for
the same purpose, but would require an additional specification for the conditional variance
p r o ~ e s sThe
. ~ beginning of the sample period roughly matches the year of the structural change
in the dividend process identified by the previous studies, for example, by Campbell (1991) and
Hodrick (1992). The S&P 500 index is deflated by the CPI, and the continuously compounded
return is calculated as 100 times the log differences of the real S&P 500 index.

4.1. Turner et al. (1989) Model versus GARCH Model of Stock Returns Volatility:
Preliminary Analysis
Table I reports ML estimates of the two-stage Markov-switching model of Turner et al. and
the GARCH(1,l) model of stock returns ~olatility.~
Expressions for these models are
respectively given by equations (5), (6), and (7), and (8). The plots of the conditional
variances of monthly stock returns implied by the two models are shown in Figure 1. Neither
model seems to be satisfactory in describing stock returns volatility. For example, the Turner
et at. model does not seem to capture enough variation in volatility when compared to the

0
1952.02

1957.12

1963.1

1969.08

-Turner

1971.08

1981.04

1987.02

1992.12

et el. -'-GARCH(l,ll

Figure 1. Measures of stock returns volatility from Turner et al.'s two-state Markov switching model and
the GARCH( 1 , l ) model
~~

4See, for example, Hamilton and Susmel (1993) who introduce the ARCH and the leverage effect in the conditional
variance process for the weekly value-weighted NYSE returns. Note that the isolation of the short-run dynamics of
fads using the data with finer frequency than monthly is not essential in addressing the issue of the predictability of
stock returns over the three to five years evidenced in the previous literature.
'In estimating the Turner et al. model, p i , and pa, were constrained to lie between zero and one. These inequalities
were ensured by parameterizing p W = (1 +exp(-O,))-'
and p,, = (1 + e x p ( - e l , ) ) - ' . Higher-order GARCH models
were also tried, but were insignificant.

46

C.-J. KIM AND M.-J. KIM

Table I. ML estimates of Turner et al.'s twostate Markov switching model and GARCH
model: 1952.1-1992.12
~

~~

Turner et al.

PI,

tim
UI
80

ci

0.9872
0.7037
3.8197
9.7 106
0.3600

(0.0142)
(0*1811)
(0.1768)
(2.7394)
(0.18 18)

- 1387.72

Log likelihood

GARCH
1.4274
0.0594
0-8621
9.3248
0.2817

Log likelihood

(0.7684)
(0.0253)
(0.052 1)
(7.5403)
(0.1836)

- 1395.05

Note: Figures in parentheses are asymptotic standard

errors. Data are the first differences of the natural
logarithm of the real S&P 500 index, adjusted by the
CPI and multiplied by 100, and are obtained from
Ibbotson Associates.

GARCH model. But the volatility from the Turner et al. model appears to return more quickly
to normal levels after the '87 crash than the GARCH model. These inferences, however,
cannot be made without considering the two standard error confidence bands of the conditional
volatility from the Turner et al. model. Perhaps the two standard error confidence bands of
conditional volatility from Turner et aZ. model may trap the GARCH model volatility or vice
versa.
In order to obtain the confidence bands, we consider the effect of uncertainty about
parameters on measured volatility. Let 6 = (ji,S,: S:, &, 811)'denote the ML estimate of the
population parameters for the Turner et al. model in equations (5)-(7) with the transition
probabilities parameterized as in footnote 5. Let d denote the asymptotic covariance matrix of
6'as estimated from second derivatives of the log likelihood. Following Hamilton and Susmel
(1993), we generated 1000 values for the vector 8 drawn from a multivariate normal
distribution, MVN(b,6). For each 8; (i = 1,2, ..., lOOO), we calculated conditional volatility
(S2,(i))using actual return data. The two standard error confidence bands were then calculated
by
[8;,-2 xSE(6ir),8;,+2x SE(Si,)]
(15)
where

47

TRANSIENT FADS

and

An alternative procedure for estimating parameter uncertainty is the Bayesian Gibbs sampling
methodology presented by Albert and Chib (1993).
In Figure 2 the GARCH volatility is depicted against the two standard error confidence bands
for the Turner et al. volatility. The confidence bands for the Turner et al. volatility trap the
GARCH volatility for the entire sample except for two periods; the 1960s and the period just after
the 1987 stock market crash. For the period of the 196Os, the GARCH volatility shows
significantly lower volatility than the Turner er al. volatility, which suggests that the Turner et al.
volatility may not be capturing enough variation. For the period just after the '87 crash, GARCH
volatility reveals much higher persistence than the Turner ef al. volatility. We repeated the exercise
to obtain the confidence band for the GARCH volatility (not shown here). Under the maintained
hypothesis that the Turner ef al. model is an appropriate one, we test whether the GARCH model is
an appropriate model. The confidence bands for the GARCH did not trap the Turner et al. volatility
for the entire period either. Neither model, therefore, seems to describe the data adequately.
4.2. UC-MS Model with Transient Fads
4.2 . I . Parameter estimates and discussion
Table I1 reports the ML estimates of the UC-MS model of equations (9)-(14) with an AR(2)
specification for the fad component since the likelihood ratio tests favour it. For example, an
200

-I

,!
I

.12
I

1-Turner

et nl.: plus 2SE -Turner

ef el.: minus 2SE -GARCH(l,l)

Figure 2. Confidence bands for Turner et al. volatility and GARCH volatility

48

C.-J. KIM AND M.-J. KIM

Table JI. ML estimates of the unobserved component model with Markov switching heteroscedasticity (UC-MSmodel): 1952.1-1992.12
Log likelihood

B "1
UVl

8,
BII

[.,
"el

,
8

CI
@2

ci
Log likelihood

-0.2937
0.9944
0.9338
3.8903
2.0965
0.6470
0.9853
8.8134

(0.0074)
(0.0074)
(0.0622)
(0.1791)
(0.4874)
(0.1 897)
(0.0 113)
(2.7363)

1.1682
-0.2937
0.3132

(0.1463)
(0.1399)
(0.1706)

o.oa

- 1383.29

a Constrained to zero based upon preliminary estimates.

Note: Figures in parentheses are approximate standard
errors. See note to Table I for the data description.
Expressions for the UC-MS model are given in equations
(9)- (14).

AR(4) specification yielded the log likelihood of -1382.83, compared to -1383.29 from an
AR(2) specification. The estimates of the AR coefficients that are of higher order than AR(2)
were also individually insignificant.
In estimating the model, we initially imposed no constraints on any of the parameters except
for (1) non-negativity constraints on standard errors (a,>O, av>O),(2) 0 c p d , p , , , p , , p , , s 1,
and (3) the stationarity condition for the fad component. One of these unrestricted MLEs fell on
the boundary 0 , = 0, which violates the regularity condition. Therefore, to calculate standard
errors we imposed oe= 0 and treated this parameter as a known constant for the purpose of
calculating the second derivatives of the log likelihood. Notice also that the construction of the
sample log likelihood involves an approximation, and thus, the reported standard errors are
approximate ones.
The estimates of the parameters associated with the fad component are of special interest.
The standard error of the transitory shocks (a,) is zero for the low-volatility state
(S,=O),while it is significant and very large for the high-volatility state (S,,= 1). The fad
component, therefore, is either on or off. Estimates of transition probabilities (p, and p , , )
indicate that the low-(zero) volatility state dominates the high-volatility state. The duration of
the high-volatility state for the transitory shocks as implied by the estimate of the transition
probability ( p , , ) is only 2.83 months. Estimates of the fad components of stock prices from the
Kalman filter are shown in Figure 3, as well as two standard error confidence bands. (Refer to
the Appendix for calculation of the confidence bands.) During the sample period, only two
episodes of statistically significant fad components are identified; one during the OPEC oil
shock and the other during the 1987 stock market crash.6These results confirm that if there exist

6Schwert (1990) also detects these two as periods with unusually high volatility.

49

TRANSIENT FADS

2o
10

-50
1952.02

1957.12

1963.1

1969.08
-Fed

component -Flus

1975.06
2SE -Minus

1981.04

1987.02

1992.12

2SE

Figure 3. Fad component of stock prices and two standard error confidence bands from the UC-MS
model

fad components in stock prices, they are only intermittent. In fact, this possibility was
conjectured by Fama and French (1988).
The UC-MS model provides a convenient tool for modelling volatility of stock returns and its
persistence. (Refer to the Appendix for calculation of conditional volatility.) Volatility of
returns from this model can be computed as the sum of the two components: volatility from the
fundamental component and volatility from the fad component. Total volatility of stock returns
and volatility from the fad component are shown in Figure 4. Total volatility from the UC-MS
model is also compared to that from the GARCH model in Figure 4.
The volatility from the UC-MS model captures most of the dynamics in the GARCH measure
of volatility, and yet the implication is very different. That is, due to the transient nature of the
shocks for the 1987 crash period, Figure 4 suggests that unusually high stock return volatility right
after the 1987 crash was mainly driven by the jump in volatility of the fad component rather than
the fundamental. Further, volatility dissipated much quickly after the crash. Volatility reverted to
pre-crash levels by early 1988 and remained low, which confirms Schwerts (1990) finding.
Another period of unusually high volatility detected by the UC-MS model is the 1973-4 OPEC
recession period, as in Schwert (1990). In the UC-MS model with two-state Markov-switching
variances for both the fundamental and fad components, however, the OPEC recession period and

It should be noted that the existence of transitory components, even though they might be short-lived, should be
interpreted with care. A persistent but transitory component may merely be a statistical artifact. Nelson (1988)
convincingly demonstrates that the unobserved component model tends to incorrectly detect cyclical variations around
a smooth trend, when data are generated by a random walk. Though it is not clear to what extent his argument applies
to our model, we cannot rule out the possibility that we have found two different types of permanent shocks in the
stock prices, one of which is transient. Therefore, the evidence is only indicative.

50

C.-J. KIM AND M.-J. KIM

70

60

50

40

30

1962.02

1957.12

-- GARCH(l.11 -UC-MS:

1963.1

Fad volatility -UC-MS:

1989.08

1975.06

1981.04

1987.02

1992.12

Total volatility

Figure 4. Measures of stock returns volatility from the UC-MS model and the separate contribution of
the fad component

the 1987 stock market crash period are treated the same; that is, both come from the same state.
Furthermore, the magnitudes of volatility for the two episodes are very similar. This suggests that
return volatility due to the fad component could have been modelled as a three-state Markovswitching variance. But this paper did not attempt this, as the unobserved component two-state
Markov-switching variance was sufficient to capture the general picture.
To examine the impact of unusual events on the estimation results, the two models are reestimated using a subsample that excludes the 1987 market crash. When volatility from the UCMS model is compared to the GARCH model based on estimates of the parameters for the
1952.1-1987.9 subsample period, the two measures of volatility are quite similar in terms of their
patterns and magnitudes, although the temporary volatility seems to dissipate somewhat quicker
for the UC-MS model. In addition, there is no significant difference between the two models in
terms of persistence of volatility during the OPEC recession; both models yield much more
prolonged volatility during the recession period (for example, the persistence measure from the
UC-MS model for the sample excluding the crash was pd + p,, - 1 = 0.7608, compared to the full
sample estimate of 0.6323). Thus, the effect of including the crash period is clear; the shock
effects become larger and the persistence of the transitory component becomes smaller. The
market responded correctly to the temporary shock by recovering stock return volatility quickly
after the crash, as documented in Schwert (1990) and Engle and Lee (1992).

4.2.2. Forecasts of volatility

The adequacy of the UC-MS model is further examined by comparing the one- to six-monthahead forecasts from different models. Table I11 reports the average values of
I l i f + , - E ( ~ f +q~rI) (and [li:+,-E(~f+~I
l y r ) ] * , K = 1, ..., 6 months, in sample and out of
Results are available from the authors upon request.

51

TRANSIENT FADS
Table III. Comparison of forecasting performances
In-sample
Month

Turner ef al.

GARCH

Out-of-samplea
UC-MS

Turner et al.

GARCH

UC-MS

MAE^
18.949
19.216
19,337
19.282
19.248
19.266

1
2
3
4
5
6

19.190
19.359
19449
19-460
19.476
19.485

18.867
19.012
19.146
19.072
19.205
19.237

20-961
19-601
19.366
19.719
19.773
18.678

21.854
20.3 17
19.854
20.161
20.409
19.082

20-917
19.689
19.498
19.845
19-903
18.841

MSE'
1
2
3
4
5
6

1540.70
1578.73
1586.46
1583.98
1585.11
1586.42

1548-60
1565.20
1569.48
1573.67
1574.94
1573.92

152344
1544.06
1559.12
1549.63
1556.96
1562.92

985.26
884.14
856.17
866.22
865.70
792.06

990.03
888.90
856.99
876.55
883.99
793.93

965.77
867.47
841-78
853.59
856.64
783.85

"Basedupon estimates using the 1952.1 to 1989.12 period.

"Average of 1 fi:+K - E(u:+ I V f ) / , K = 1 , ...,6 months.
'Average of [ii:+K- E(u:,,lf V,)] , K = 1 , ...,6 months.
Note: a, for the UC-MS model is equivalent to v, I ,-,in equation (A.9) of the Appendix.

sample, denoted by MAE and MSE, respectively.' Out-of-sample comparisons are based upon
ML estimates using the data for the 1952.1-1989.12 period.
As for in-sample forecasts, the UC-MS model is the best in terms of minimizing both MSE
and MAE. Out-of-sample MSEs also suggest likewise. Exceptions are made to out-of-sample
MAEs, for which the Turner et al. model yielded the smallest values for two- to six-monthahead forecasts. (Even in this case, the differences in the out-of-sample MAEs are nearly
negligible for Turner et al. model and UC-MS model.) In all cases, GARCH(1,l) yielded the
largest MAEs and MSEs.

4.2.3. Efects of parameter uncertainty in the UC-MS model

General implications that emerge from Section 4.2.1 are that (1) the volatility from the UCMS model captures most of the dynamics in the GARCH measure of volatility; and (2) there
exist periods with significant fad components which are transient; and consequently, (3)
volatility reverted to normal levels very quickly after the crash, and more quickly than is implied
by the GARCH model. These implications have been drawn based on the final parameter
estimates of the model. However, it is not clear whether these implications continues to hold if
parameter uncertainty is incorporated. In this section we investigate whether similar inferences
can be drawn when an uncertainty in the parameters of the model is explicitly taken into account.
As in Section 4.1, let 8 = @, a;,
&ll,65, 8&, bclr8&,dvl, 2,)' denote the
ML estimate of the population parameters for the UC-MS model." Let 6 denote the covariance

a, for the UC-MS model is equivalent to vf I

- I in equation (A.9) of the Appendix.

Ore, OC1.Oa4, O,,, are introduced to constrain p a o ,p L , ,plo
, and pel,the transition probabilities, to lie between zero and
one.Thatis,p,,= (1 +exp(-O,,))-',p,, = ( l + e x p ( - O , , ) ) - ' , p , , , = (1 + e x p ( - e , , o ) ) - l , p , , , =(1 +exp(-O,,,))-'were
employed for this purpose. Similarly, T, and t 2are employed to constrain &I and & 2 within a stationary region.
I"

52

C.-J. KIM AND M.-J. KIM

matrix of 8 as estimated from second derivatives of the log likelihood. Then, as in Section 4.1
and Hamilton and Susmel (1993), we generated 1000 values for the vector 6 drawn from a
MVN(6,d). We denote 6 ;as the ith realization of 6 from a multivariate normal distribution.
For each 6 ;( i = 1,2, ..., 1000) we calculated the fad component, its variance, and the implied
volatility of the stock returns, namely, the (1, 1) elements of 5, I ,, R, I , and H I I ,, r = 1,2, ..., T ,
using notations introduced in the Appendix, using actual returns data. Define these as z,(i), r , ( i )
and H,(i), respectively. The two standard-error confidence bands for the implied volatility can
be calculated as:
{ R, - 2 x SE(H,),R, + 2 x SE(H,)]

(16)

where

and

-/

SE(H,)=

1000

i=l

To obtain the confidence bands for the fad component that incorporate parameter uncertainty,
= z,(i) - 2 m ) for the
we first consider the confidence bands for each generated 6;:aRL(i)
= z,(i)+ 2 a ) for the upper bound. Then the two standard confidence
lower bound and %,(i)
bands for the transitory component with parameter uncertainty can be calculated as:
{ !?ZiL - 2 x SE(%L),B, + 2 x SE(%,)]

(17)

where

a,

loo0

and
and SE (3), are calculated in the same way.
In Figure 5 the two standard-error confidence bands for volatility from the UC-MS model
with parameter uncertainty are depicted along with the GARCH measure of volatility. The
confidence bands trap the GARCH volatility for all the periods except just after the 1987 crash.
For this period, the GARCH measure of volatility reveals much more persistence. In addition,
unlike the Turner et al. model in Section 4.1, the confidence bands from the UC-MS model trap
the GARCH volatility during the 1960s, suggesting that the model captures enough dynamics in
volatility.
Figure 6 depicts the confidence bands for the transitory component of stock prices that
incorporate parameter uncertainty. With parameter uncertainty, the two standard error
confidence bands are much wider than those based on maximum llkelihood estimates without
parameter uncertainty. However, the UC-MS model continues to identify one month during the
OPEC recession and the month of '87 stock market crash as periods showing a statistically
significant fad component. Except for these two episodes, estimated fads are almost always
negative, but insignificant. The previous literature conjectures that bubbles tend to grow rapidly,

53

TRANSIENT FADS
160 -

I
140 - 120 ..

loo ..
80 - 60
40

20
0
1957.12

1963.1

1969.08

1d75.06

1981.04

1987.4

1992.12

-20

--

L__UC-MS: plus 2SE -UC-MS: minus 2SE -GAkHII.1)/

-_._

Figure 5. Confidence bands for stock returns volatility from the UC-MS model with parameter
uncertainty versus GARCH volatility

1952.02

1957.12

ls63.1

1969.08

1-

Minus 2SE -Plus

1975.06

2SE

1981.04

1987.02

1992.12

Figure 6. Confidence bands for the fad component from the UC-MS model with parameter uncertainty

54

C.-J. KIM AND M.-J. KIM

as unreasonable expectations become self-fulfilling, and they shrink at a rapid pace as they burst
or crash. Interestingly, Figure 6 suggests that there is little evidence of such systematic rises in
the market prior to the periods with significant fads.
5. SUMMARY AND CONCLUSIONS
A fad model with Markov-switching heteroscedasticity in both the fundamental and fad
components (UC-MS model) is introduced to examine the nature of transitory components in
stock prices. Using the monthly real S&P index returns for the January 1952 to December 1992
period, this paper finds that the extremely large shocks during the 1987 stock market crash may
be one example of short-lived fads. Another episode of transient fads occurred during the
1973-4 OPEC recession period. ML estimates of the UC-MS model suggest that such fad
components last, on average, about three months. Given the sample size examined in this paper,
periods in which the mean-reverting transitory component becomes significant appear to be far
less frequent than is conjectured by earlier models such as the noise trader model.
When parameter uncertainty was incorporated into the model, only one month during the
OPEC recession and the month of 87 stock market crash were identified as episodes of
statistically significant fads. It is intriguing that fads depicted in Figure 6 are typically
insignificant, but negative. Given that the model specification in this paper is correct, the results
are economically interesting. While we usually think of fads as speculative bubbles, what the
model seems to be picking up is unwarranted pessimism which the market exhibited with the
OPEC oil shock and with the 87 crash. In addition, although there was a brief period of
insignificant, but positive 2,s prior to the October 1987 market crash, the magnitude of z,was
far too small to be interpreted as a prelude to the possible burst of bubbles.
It has been also pointed out by the literature that the standard GARCH-type model is not
capable of modelling the markets quick adjustment of the volatility to large and infrequent
shocks. Hamilton and Susmel (1992), for example, calculate the probability of the occurrence
of an episode like the 1987 stock market crash to be less than one in 10,000,under the normality
assumption. Also, the 1987 crash is characterized by the largest percentage change in market
value in over 29,000 days since 1885 (Schwert, 1990, p. 77). By decomposing stock returns
volatility into the portions that are contributed by the fundamental and fad components, this
paper shows that unusually high stock return volatility after the 1987 stock market crash was
indeed mainly due to the jump in volatility of the fad component rather than the fundamental. In
addition, the UC-MS model implies that the market returned to a normal level very quickly. This
finding is consistent with Schwert (1990), Engle and Mustafa (1992), Engle and Lee (1992),
and Hamilton and Susmel (1992). When parameter uncertainty is considered for the UC-MS
model, the same implications result.
APPENDIX

(1) UC-MS Model

where

55

TRANSIENT FADS

with

E[c?,<] = Q, =

E[v:] = u:,

a:,= (1-Sw,)aZ,+S,,a2,,, u:,>u$

('4.4)
u,2r=(1-Se,)u~+Seru,21,
u,zl>uL
(A3
where S, and S, are discrete valued, unobserved first-order Markov-switching variables that
evolve independently of each other according to the following transition probabilities:

fi[S,,= 0 I S v , r - l = 01 =
h[S,t=O

I Se.t-1

=OI =p&o.

fils,,= 1 I Sw,t-, = 1 I = pwl

h[Se,= 1 I
11 =pel

(A.4)

Se,r-l=

(2) Estimation

For a given realization of the state variables at time t and t - 1 (Su,t-l= s,, S,,= s',,, Se,,-l= se
andS,, = s
, where s ,, s',,, set s: = 0 or l ) , the Kalman filter can be represented as follows. The
:
notation y,?";, for example, means that the variable y , is dependent upon the realizations of the
state variables S w , , - , = s, and S,, =.:s
=

p"fe

(A-7)

Zt- I I r - I

s s P'

+ Qs'

R,;,f; =
S"J<

rlrlr-

= Yr -

aztIr- I

(A4
04-91

-P

- :.,s.,s - I
2s;
- dR,I,-la + 0,

s,s,.s:s:
fqt-1
-.,.s,s;,s:

-&Y"Pc

= @Zrlr-l

ztlt
5 5

-s"Je

s's:

(A.lO)

s J P'd

+ K "' "
s P P' s'

S"S,

(A.ll)

'VtIt-1

s",s,J:

R , y " =(z-K,"'"''d)R,I,-I

(A.12)

where I denotes a two-dimensional identity matrix and

I

s s J",S<

K,"'
'

s,,s,.s:

= R,I,-

-, s s s' s'
(H,p,I ,"' r)-l

(A.13)

The dimension of the (2 x 2 x 2 x 2) posteriors ( f ~ , y s e s ; * sand

~
R:r;ses;.s;)
needs to be reduced
to (2 x 2) by taking weighted averages over states at t - 1, in order to make the Kalman filter
operable. The following explains how this can be done:
1

1
C
q, =
-s:.s;

S"

~ [ ~ u ,1 t=-

su, Se,,- I = se, ~ u =, s:, Se, = si 1 %*I x

S< * 0

fi[Sur = sl, Set = s:

S""0

I #I

<::.:s
s s

(A.14)

Sc'O

(A. 15)

56

C.-J. KIM AND M.-J. KIM

The appropriate probability terms can be obtained as follows:

where

arid

with

Notice that equation (A.19) results from the assumption that the two state variables S,, and S,,
are independent. As a by-product of running the above Kalman filter, the conditional loglikelihood function can be obtained from equation (A. 18). The sample conditional loglikelihood is
7

(A.2 1)
In fact, equation (A.21) is an approximation to the log-likelihood function, as the filter
involves approximations. For details on the nature of approximations involved, refer to Kim
(1993, 1994). ML estimates of the model can be obtained by maximizing the log-likelihood
function (A.21) with respect to the unknown parameters, using a nonlinear optimization
procedure.

(3) Calculation of Conditional Volatility Implied by the UC-MS Model

From the Kalman filter algorithm provided above, the conditional forecast error variance is
given by:

H,s,v;2,G*si
= & R r s , v ; f e i s L ; d r + ot5

(A.22)

TRANSIENT FADS

57

which is dependent upon states at time t and t - 1 (i.e. S,,= s6, 5 ' p , r - i = s,, S,,, = s',,, Su.r-l= s,,,
with s,,, s',,, s,, s6 = 0, or 1). The first element in the right-hand side of equation (A.22) is the
portion of return volatility that is less persistent and is a function of o:? For example, degree of
persistence based on estimates in Table I1 was fl + f l u l - 1 = 0.9343. These two components of
volatility with different levels of persistence could be interpreted as transitory and trend
volatility, respectively, as in the case of Engle and Lee (1992).
Using equation (A.22) and filtered probabilities of states, the conditional variance of returns
based on available information can be calculated as:

where

T#-

is information available at time t - 1.

(4) Calculation of Confidence Bands for the Fad Component

and
in equations (A.11) and (A.12) of the Kalman filter are used to compute
the estimates of the fad component and its variance conditional on available information and on
states at times t and t - 1. Let
5 A".)

s'v .s'

Rr5~;SpS;.'b

rI

s,=0

S" = 0

s,=0

s:,=0 s:=0

s, = 0 .s; = 0 s; = 0

(A.25)
where W , refers to information available at time t. Then, the fad component (denoted by z * I~,)
amounts to the (1 , l ) element of the vector i,I ,. and the corresponding variance (denoted by
R*, ,) amounts to the (1 , l ) element of the covariance matrix R, I ,. Therefore, the two standard
error confidence bands for the fad component are calculated by z*,I f 2 x
ACKNOWLEDGEMENTS

Please direct correspondence to Chang-Jin Kim (Fax: 01 1-82-2-926-1301, Internet: cjkim

@kuccnx.korea.ac.kr) or Myung-Jig Kim (fax: 205-348-0590, Internet: mkim@alston.
cba.ua.edu). The authors are grateful to Robert Brooks, James Cover, Benton Gup, Charles R.
Nelson, John L. Silver, and Richard Startz for insightful comments and suggestions. The
authors also thank JAE co-editor John Geweke and four anonymous JAE referees for detailed
comments that have substantially improved the paper. Responsibility for any errors, however, is
entirely the authors'. The first author would like to acknowledge with thanks the support from
Korea University and the Social Sciences and Humanities Research Council of Canada under
grant number 410-93-0361.

58

C.-J. KIM AND M.-J. KIM

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