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Introduction Structural Breaks

• Discuss the problems associated with
structural breaks in the data.
• Examine the Chow test for a structural
break.
• Assess an example of the use of the Chow
test and ways to solve the problem of
structural breaks.
• Introduce the problem of multicollinearity.
• Structural breaks can occur in time series data
or cross sectional data, when there is a sudden
change in the relationship being examined.
• Examples include sudden policy changes such
as a change in government or sudden move in
asset prices (1987) or serious international
disaster such as a civil war
• We then need to decide whether 2 separate
regression lines are more efficient than a single
regression.

Structural Break in 1997 Structural Break

• In this example a single regression line is
Index not a good fit of the data due to the
obvious structural break in 1997.
stock prices

30
20 • We need to test if a structural break has
10
occurred in 1997, usually the break is not
0
1985 1990 1995 2000 2005 2010
as obvious as this.
date • We will use the Chow test, which is a
variation of the F-test for a restriction
SP Linear (SP)

Chow Test (stages in using test) Chow Test

• Run the regression using all the
observations, before and after the RSS c  ( RSS 1  RSS 2 ) / k
F
structural break, collect the RSS RSS 1  RSS 2 / n  2 k
• Run 2 separate regressions, one before,
RSS(1) and one after, RSS(2) the RSS c  combined _ RSS
structural break. RSS 1  pre  break _ RSS
• Calculate the test statistic using the
following formulae:
RSS 2  post  break _ RSS

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Chow Test
• The final stage of the Chow Test is to
compare the test statistic with the critical
value from the F-Tables.
• The null hypothesis in this case is
structural stability, if we reject the null
hypothesis, it means we have a structural
break in the data
• We then need to decide how to overcome
this break.
Chow Test Example
• The following model is regressed using data
in quarterly form from 1990 to 2005 (64
observations)for Malaysian stock prices
against output (structural break in 1997).
st   0  1 yt  ut
Chow Test
• As the critical value for F(2,60) =3.15(5%)
• As 12> 3.15, we reject the null hypothesis
of structural stability.
• We conclude that there is a structural
break in this model, we need to split the
data into 2 sub-samples or use another
method to overcome the break.
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Chow Test
• If there is evidence of a structural break, it
may mean we need to split the data into 2
samples and run separate regressions.
• Another method to overcome this problem
is to use dummy variables (To be covered
later in term), the benefit of this approach
is that we do not lose any degrees of
freedom through a loss of observations.
Chow Test
• The first regression using all the data produced a
RSS( c) of 0.56, then 2 regressions were run on a
sub-sample of the data from 1990-1997, giving a
RSS(1) of 0.23. The final regression was on the
sample from 1998 to 2005, producing a RSS(2) of
0.17, n=64, k=2.
F
0.56 (0.23 0.17) / 2

0.08
12
0.23 0.17/ 64 2*2 0.00667
Problems with Chow Test
• The test may suggest splitting the data,
this may mean fewer degrees of freedom
• When should the cut off point be for the
test, usually there should be a theoretical
basis for this.
• There is the potential for structural
instability across the whole data range. It
is possible to test every observation for a
structural break.
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CUSUM TEST The Predictive Failure Test

• Cumulative Sum – Monitors for structural • Problem with the Chow test is that we need to have enough data to do the
change. When summing a errors, when it regression on both sub-samples, i.e. T1>>k, T2>>k.
• An alternative formulation is the predictive failure test.
hits a critical value then …break. • What we do with the predictive failure test is estimate the regression over a “long”
sub-period (i.e. most of the data) and then we predict values for the other period
40 • Vie Stability Diagnostics and compare the two.
30

20 • Recursive estimates To calculate the test:

10

0
• CUSUM - Run the regression for the whole period (the restricted regression) and obtain the RSS
- Run the regression for the “large” sub-period and obtain the RSS (called RSS1). Note
-10
we call the number of observations T1 (even though it may come second).
-20
RSS  RSS1 T1  k
-30
Test Statistic  
RSS1 T2
-40
04 05 06 07 08 09 10 11 12 13 14 15 16
where T2 = number of observations we are attempting to “predict”. The test statistic
CUSUM 5% Significance
will follow an F(T2, T1-k).
‘Introductory Econometrics for Finance’ © Chris Brooks 2008

Backwards versus Forwards Predictive Failure Tests Predictive Failure Tests – An Example

• There are 2 types of predictive failure tests: • We have the following models estimated:
For the CAPM  on Glaxo.
- Forward predictive failure tests, where we keep the last few • 1980M1-1991M12
observations back for forecast testing, e.g. we have observations for 0.39 + 1.37RMt T = 144 RSS = 0.0434
1970Q1-1994Q4. So estimate the model over 1970Q1-1993Q4 and • 1980M1-1989M12
forecast 1994Q1-1994Q4. 0.32 + 1.31RMt T1 = 120 RSS1 = 0.0420
Can this regression adequately “forecast” the values for the last two years?
- Backward predictive failure tests, where we attempt to “back-cast” 0.0434 0.0420 120 2
the first few observations, e.g. if we have data for 1970Q1-1994Q4, TestStatistic  = 0.164
0.0420 24
and we estimate the model over 1971Q1-1994Q4 and backcast
1970Q1-1970Q4. • Compare with F(24,118) = 1.66.
So we do not reject the null hypothesis that the model can adequately
predict the last few observations.

‘Introductory Econometrics for Finance’ © Chris Brooks 2008 ‘Introductory Econometrics for Finance’ © Chris Brooks 2008

How do we decide the sub-parts to use? Dummy Variables

• As a rule of thumb, we could use all or some of the following: • Dummy Variables are a common way of solving
- Plot the dependent variable over time and split the data accordingly to any structural breaks, as it does not involve splitting
obvious structural changes in the 1400
the data.
series, e.g. 1200 • These variables consist of 1s and 0s and are
1000 often termed ‘on-off’ variables.
Value of Series (yt)

800

600
• They can be used to determine the importance
400
of policy actions on models and are often used
200 to account for qualitative effects.
0
• Their coefficients and t-statistics can then be
105
131
157
183
209
235
261
287
313
339
365
391
417
443
1
27
53
79

- Split the data according to any known

Sample Period
interpreted in the usual way.
important historical events (e.g. stock market crash, new government elected)
- Use all but the last few observations and do a predictive failure test on those.
‘Introductory Econometrics for Finance’ © Chris Brooks 2008

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Sequential Bai-Perron
• The default Method setting (Sequential L+1 breaks vs. L) instructs
EViews to perform sequential testing of l+1 versus l breaks using the
methods outlined by Bai (1997) and Bai and Perron (1998).
• There is a single regressor “C” which we require to be in the list of
breaking variables.
• By default, the tests allow for a maximum number of 5 breaks,
employ a trimming percentage of 15%, and use the 0.05 significance
level for the sequential testing. We will leave these options at their
default settings. We do, however, select the Allow error
distributions to differ across breaks checkbox to allow for error
heterogeneity.
• Click on OK to accept the test specification and display the test
results. The top portion of the dialog shows the test settings,
including the test method, breakpoint variables, test options, and
method of computing test covariances. Note that the test employs the
same HAC covariance settings used in the
Multi-breaks
EViews displays the F-statistic, along with the F-statistic scaled by the
number of varying regressors (which is the same in this case, since we only
have the single, varying regressor), and the Bai-Perron critical value for the
scaled statistic. The sequential test results indicate that there are three
breakpoints: we reject the nulls of 0, 1, and 2 breakpoints in favor of the
alternatives of 1, 2, and 3 breakpoints, but the test of 4 versus 3 breakpoints
does not reject the null. The bottom portion of the output shows the
estimated breakdates:
EViews displays both the breakdates obtained from the original sequential
procedure, and those obtained following the repartition procedure. In this
case, the dates do not change. Again bear in mind that the results follow the
EViews convention in defining breakdates to be the first date of the
subsequent regime.
Global Information Criteria
• Lastly, we consider using information criteria to select the
number of breaks.
• Here we see the dialog when we select Global information
criteria in the Method dropdown menu. The top and bottom
portions of the output are similar to the results seen
previously so we focus only on the test summaries
themselves:
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Global Bai-Perron L Breaks vs. None
• To perform the Bai-Perron tests of l globally optimized
breaks against the null of no structural breaks, along with
the corresponding UDmax and WDmax tests, simply call up
the dialog and change the Method drop-down to Global
L breaks vs. none:
• We again leave the remaining settings at their default
values with the exception of the Allow error
distributions to differ across breaks checkbox which
is selected. Click on OK to perform the test.
• The top portion of the output, which shows the test
settings, is almost identical to the output for the previous
example. The only difference is a line identifying the test
method as being “Bai-Perron tests of 1 to M globally
determined breaks.”
• The first four lines summarize the results for different approaches to determining
the number of breaks. The “Sequential” result is obtained by performing tests from
1 to the maximum number until we cannot reject the null; the “Significant” result
chooses the largest statistically significant breakpoint. In both cases, the multiple
breakpoint test indicates that there are 5 breaks. The UDmax and WDmax results
show the number of breakpoints as determined by application of the unweighted
and weighted maximized statistics. The maximized statistics both indicate the
presence of a single break.
• The remaining lines show the individual test statistics (original, scaled, weighted)
along with the critical values for the scaled statistics. In each case, the statistics
far exceed the critical value so that we reject the null of no breaks. Note that the
values corresponding to the UDmax and WDmax statistics are shaded for easy
identification.
• The last two lines of output show the test results for double maximum statistics. In
both cases, the maximized value clearly exceeds the critical value, so that we
reject the null of no breaks in favor of the alternative of a single break.
Conclusion
• The F-test can be used to test a specific
restriction on a model, such as constant returns
to scale.
• The Chow test is used to determine if the data is
structurally stable.
• If there is a structural break, we need to split the
data or use dummy variables
• Multicollinearity occurs when the explanatory
variables are closely correlated.