BUBBLES IN THE PHILIPPINE PESO-US DOLLAR EXCHANGE RATE: AN

APPLICATION OF THE GENERALIZED SUPREMUM AUGMENTED

DICKEY FULLER AND REGIME-SWITCHING MODEL1
1A thesis manuscript submitted in partial fulfillment of the requirements for graduation
with the degree of Bachelor of Science in Economics, Department of Economics, College
of Economics and Management, University of the Philippines Los Baos. Prepared under
the supervisor of Dr. Yolanda T. Garcia.

CELINE JOSON ALCANTARA

CHAPTER I
INTRODUCTION

Throughout the history, the world has experienced periodical recurrence of crises in
varying forms from different markets famous examples include the Tulip Mania in the
1630s, the Great depression in the 1930s, Black Monday in 1987, Mexican peso crisis in
1994, Asian Financial Crisis (AFC) in 1997, dotcom bubble in the 2000s, Global Financial
Crisis (GFC) in 2007, and the Debt crisis in the Eurozone in 2013. These historical events
have proved the difficulty entailed in the appropriate control measures of financial crises,
as well as its prediction beforehand. However, financial historians believe that these
financial crises, along with regime shifts, are commonly preceded by asset bubbles. Asset
bubbles are generally understood to be a deviation between market prices and its
fundamental value, that exhibits an explosive behavior and is commonly described as a
form of market exuberance, driven by the irrational behaviors of market participants and
or market failures.

In the recent decade, financial crises have occurred more persistently and frequently,
thus increasing threats and speculations on whether another global crisis is on its way.
Moreover, market bubbles in commodities, asset prices, and exchange rates have brought
forth a growing interest from numerous researchers from various fields in identifying and
forecasting bubbles during its inflationary phase or before it burst to prevent financial crisis

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and to measure the monetary policy response necessary to minimize its effect. Despite the
wide attention, literature on bubbles still lack precise methodological approach needed to
identify bubble episodes in real time and even historically.

Several attempts and proposals for new econometric tools from different fields, have
been made to address the identification and prediction of bubbles and likewise, were
plagued with reviews and criticisms throughout the academe. Gurkaynak (2008) reviewed
a large set of econometric tests and doubted the possibility of detecting a bubble, saying
that for every study on its evidence, there would be at least one paper contradicting it.
Bubbles could be indistinguishable from its time-varying fundamentals (Gurkaynak 2008).
Former Federal Reserve chairman Greenspan also recognized the complexity attached to
the bubble literature, stating in the 2002 Forum, that despite suspicions, the existence of
bubbles can only be determined when it is already bursting (The Federal Reserve Board
2002). Along with the lack of empirical evidences to bubble phenomena, there is still an
ongoing debate on the presence of bubbles in market prices, as other researchers are
uncertain as to whether it even exists. Other researchers attribute explosive behaviors in
prices and its deviation to market fundamentals as mispricing and market failures. Phillips
and Yu (2011) demonstrated that discount rates can be one factor to induce explosive
behavior in the short run prices. Cohrane (2005) also argues that there is no bubble
component in prices (as cited in Phillips et al 2014a).

In the Philippines, literature on the existence of bubbles in any of its market is still
premature and have produced varying dispositions from its short list of researchers. Most
studies have centered on the Asian Financial crisis in 1997 with the Philippines being the
least affected country. However, Glindro and Delloro (2010) argued that Philippines at that
time, still has underdeveloped financial system and hence remains unaffected by financial
crisis incidents compared to other countries that have endured severely. Nevertheless,
developed countries are not the only economies prone to financial and market instability.
The Asian Financial Crisis, the largest crisis to date for the whole Asian region had only
originated from the bubble bursting of the property and stock market of Thailand which is
only a small global market at the time.

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 Given that the world is moving towards economic integration and under the speculation
of another market instability, while still recovering from the GFC and other small asset
bubbles, studies on the existence and evaluation of bubbles in the Philippine market will
be of great importance. Moreover, Philippines has been recently under discussions of a
speculative bubble, specifically in its asset and property market as warned by the IMF in
its report in 2013. The present paper aims to contribute in this area using the Foreign
Exchange Market of the Philippines. The Philippine Foreign Exchange market can be
considered as the more prominent financial market in the Philippines and it cannot only
reflect the Philippine financial system but as well as relative to other countries, especially
those that have shown multiple episodes of crises, bubble phenomena, and may be the
source of another.

The general objective of this study is to investigate for the existence of bubbles in the
Philippine Peso-US Dollar exchange rate. Specifically, the study aims to:

1) identify significant explosive behaviors in the Peso-Dollar exchange rate as

potential bubble episodes;
2) determine the duration of the bubble episodes and date stamp its starting and
termination dates;
3) measure the bubble size present in the Peso-Dollar exchange rate;
4) test for the probability of collapse of the Peso-Dollar exchange rate as a function of
the bubble size and the early warning indicators for crisis; and
5) recommend the results of the study for the forecasting of bubbles and bubble-led
crises phenomena.

Given that most financial crises have been preceded by bubble phenomena, there is
huge interest in identifying and forecasting historical and real time bubbles. Bubble studies
are explored as it is perceived to provide early warning signals to forthcoming crises and
for the implementation of appropriate monetary policy responses to prevent further
economic losses. Employing a bubble study in a financial market such as the Philippine
foreign exchange can help policy makers provide sound monetary policy in response to the
alert signals that can be concluded by the identification of bubble episode. In the case of

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the foreign exchange market, despite having flexible exchange rates, the identification of
bubble episodes before it burst can help the Central Bank to foresee the problems and create
monetary policy responses through variables such as interest rates and money supply.
Aside from this, market traders will also benefit as they can be guided to the appropriate
positions and trading actions. Having a stabilized exchange rate also provides secure
trading in the global market since majority of the countrys trade are quoted in US Dollars,
thus helping both consumers and producers in general.

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 CHAPTER II
REVIEW OF RELATED LITERATURE

Market bubbles definition, nonetheless its identification, prediction, and policy

response, remains indefinite in any of its existing literature that has persisted to be in the
center of various studies especially until the Global Financial Crisis (GFC) in 2007. The
GFC which has affected and caused crises of different markets from different countries,
brought an alarm to the increased globalization and the risk associated with the
transmission of financial disruptions. Historically, bubble phenomena can be traced back
as early as the 1630s with the Dutch Tulip Mania and has been virtually around in any
market such in metal and agricultural commodities, real estates, exchange rates and stocks.
The perplexing yet periodical occurrence of bubbles has led to researchers increased
interest in identifying and explaining it using both ex-post and ex-ante analysis, with more
emphasis on the latter so as to prevent forthcoming crises. Academicians from different
fields have produced extensive yet different approaches to identify or predict bubble
episodes that various models have emerged mostly in the concept of rational
expectations, behavioral traders, and heterogeneous and bias belief of investors or traders.
Despite the different approaches adopted, bubbles are generally understood to be a
substantial deviation in asset prices from its fundamental value.

A. Philippine Literature on Bubbles

In the Philippines, literature on market bubbles seems scarce despite being in the center
of bubble speculations with its property and asset markets as it has continuously shown
growth for years. However, before these speculations, previous studies were only focused
on the effect of the Asian Financial Crisis (AFC). Philippines was known for being the
least affected country and having the fastest recovery. However, Vital and Laquindanum
(2005) claim that the extent of the crisis effect to the Philippines, is still yet to be quantified
though there are strong evidence of asset price changes. Vital and Laquindanum (2005)
also suggest that the Asian financial crisis was more felt in the economic environment such
as in the investor confidence rather than directly through stock volatility. Collyns and
Senhadji (2002), studying the boom-bust cycles present among the affected countries

5
namely, Thailand, Malaysia, Indonesia, Korea, and Philippines, reported that the crisis was
led by optimistic expectations on East Asian rapid economic growth, increased capital
accumulation, underdeveloped banking system and inadequate regulatory governance on
financial markets, thus eroding barriers to moral hazard. The study found that boom-bust
swings were most notable in Indonesia while the Philippines did not show fluctuations in
the stock prices of the property sector relatively to all shares (Collyns and Senhadji 2002).
In fact, the Philippines experienced the least property price cycle despite strong showing
from other affected countries. However, the study can be considered limited in capturing
property price inflation since the CPI index along with property index in stocks the proxy
data for other countries and the Philippines did not show significant inflation in Thailand
when it experienced the most extreme property price cycle. Using descriptive statistics of
McQueen and Thorleys duration dependence test, Nartea, Hu, and Hu (2013) also
examined the presence of rational speculative bubbles during the Asian Financial Crisis,
however, this time, focusing solely in the Philippine stock market using both weekly and
monthly returns over the period of 1991 to 2009. Nartea et al (2013) did not detect any
presence of bubbles however, suggests that there may be overlooked bubbles made by
irrational investors and thus, needs further research. While the descriptive statistics yielded
inconclusive results, the authors also recognized the possibility of their tests lack of power
to detect bubbles (Nartea et al 2013).

On the other hand, Glindro and Delloro (2010), found evidence of bubbles in the
exchange rate and stock markets using a decomposition analysis decomposing asset prices
into fundamentals, cyclical and bubble components using the Kalman filter of three asset
markets: foreign exchange, stock, and housing markets. While the housing market did not
have any indication of bubble episode, the study did not record any excessive bubbles for
both the foreign exchange and stock markets. Glindro and Delloro (2010), primarily credit
this result to the underdeveloped financial market and low participation in stock
investment. Also, though there is already great flexibility in the foreign exchange market,
it is still aligned with the conservative approach of the Philippines monetary policy
(Glindro and Delloro 2010). This was also reflected in the paper of Corsetti, Pesenti and
Roubini (n.d.) about the Asian Financial Crisis, suggesting that the Philippines, having

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poor credit market, low stocks market participation and low property exposure in the
banking system at the time, could contribute to why increased property prices did not
reflect in most studies about bubbles in the Philippines.

Another bubble study involving the Philippines with the use of yet another method is
from Hu and Oxley (2016). The study applied the GSADF test over a wide number of
exchange rate markets, specifically, those countries that are part of the G101, BRICS2, and
some Asian emerging countries3 which includes the Philippines. Hu and Oxley (2016)
using monthly exchange rates of Philippine Peso/US Dollar from 1991 to 2012, rejects the
null hypothesis of no bubble at 1 percent in the Philippine nominal exchange rate against
the dollar during the August of 1997 to October of 1998, accounting the Asian Financial
Crisis, and in December of 2006 to May of 2008, conferring to the global financial crisis.
Furthermore, testing the nominal exchange rate subject to traded and nontraded goods, Hu
and Oxley (2016) suggest that traded goods played crucial roles in the exchange rates
explosive behavior. Despite the similarities in the scope, the paper however will differ by
employing an exchange rate determination model to measure the bubble size and by
computing for the probability of collapse relative to early warning indicators in exchange
rates. Another recent study is by Caramugan and Bayacag (2016), employing the GSADF
and SADF with selected ASEAN agricultural exports namely, rice, rubber, and palm oil,
which can be considered as the benchmarks in agricultural commodities among the
ASEAN countries. The study found multiple bubble phenomena with particular
concentrations of exuberance during the 2006-2008. The authors related this phenomenon
to factors such as low market stocks, competitions across industries, oil price hikes, and
persistent devaluation of the US dollar which is the currency used to quote the export
commodities in the study.

1 Currencies in the countries part of the G10 used are British pound, Canadian dollar, Japanese yen, Norwegian krone,
Swedish Krona, and Swiss franc
2 Currencies used from BRICS are Brazilian Real, India Rupee, South African Rand, Colombian Peso, and Mexican

Peso
3 Currencies from emerging countries used in the study are Korean won, Malaysian Ringgit, Indonesia Rupiah,

Singapore Dollar, and Philippine Peso

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 B. Financial Crises

Financial crises are thought to transpire from bank failures, bursting of asset price
bubbles or large fluctuations in exchange rates from rapid changes in the economic
environment (Kindleberger and Aliber 2005). Commonly, financial crisis is triggered by a
booming period of asset prices, and potentially asset bubbles, followed by a crash
(Brunnermeier and Oehmke 2012). Asset bubbles are understood as the deviation between
market prices and its fundamental value that exhibits explosive behavior in price changes
or cash flows. Asset bubbles are also thought to precede most financial crises in history as
it induces market collapse once burst (Brunnermeier and Oehmke 2012). Since the 1970s,
financial crises have surfaced more frequently and more severely, coupled with increased
volatility of prices in the commodities, currencies, stocks, and real estates. Some of the
notable financial crises are the AFC, Dotcom Crisis, and the GFC.

B.1. The Asian Financial Crisis

One train of thought in the literature of financial crises is that financial crises are
systematically related. In the 1980s, the bursting of the asset price bubble in Japan led to a
decade of sluggish economic growth and consequently directed cash outflows from Japan
to other countries including Thailand, Malaysia, Indonesia and the US. In the mid-1990s,
the inflow of money led to the appreciation of their currencies and price increases in real
estate and stock prices with also the US, Japanese and European firms investing to its low-
wage, low-cost sources of supply. These countries, Thailand, Malaysia, and Indonesia at
the time were considered to be dragon economies which are thought to emulate the
economic success of the East Asian countries such as South Korea, Hongkong or
Singapore. However, Thailand experienced large loan losses on its domestic credits in 1996
(Kindleberger and Aliber 2005). This was followed by a sharp decline in the purchase of
Thai securities of which the Bank of Thailand failed to accommodate due to its lack of
available foreign reserve. Thus, Thai baht experienced a sharp decline of value in July 1997
for as high as 30 percent which led to the capital (Kindleberger and Aliber 2005). The
bursting of the asset price bubble and the devaluation of the Thai baht in 1997 actuated a

8
contagion effect among most Asian countries including Malaysia, South Korea, Japan, and
Philippines. This became known as the Asian Financial Crisis.

B.2. The Dotcom Crisis

When the bubble imploded in the Southeast Asia, the US experienced another surge in
capital inflows which steered further the appreciation of the US dollar and its economic
growth. At the same time, the US is experiencing a market boom in its information
technology which also helped the increased investment in stocks trading. Most firms such
as Microsoft, Cisco, Dell, and Intel chose not to obtain a listing on the New York Stock
Exchange (NYSE) and instead went to NASDAQ because electronic trading of stocks may
yield greater profit. Thus, market value of stocks traded in NASDAQ relative to the NYSE
experienced high growth, from 19 percent in 1995 to 42 percent in 2000 (Kindleberger and
Aliber 2005). However, in 2000, the same year the 42 percent growth was recorded,
technology related stock prices began to decline (Kindleberger and Aliber 2005). This
decline persisted and became known as the Dotcom Crisis. However, despite the continued
decline in prices of technology-related stocks, the crisis was short lived (Brunnermeier and
Oehmke 2012).

B.3. The Global Financial Crisis

With the implosion of the Dotcom bubble and investors desperate to move capitals, the
real estate market in the early 2000s experienced an over optimism with increased prices.
The combination of low interest rates, financial innovation in the form of mortgage
securitization, and a global saving glut, however, led to a bubble in the US real estate price.
However, the bubble started to burst and reverse in 2007 leading to the default of most US
financial institutions, most notably the Bear Stearns and Lehman Brothers in 2008
(Brunnermeier and Oehmke 2012). The collapse of the real estate bubble in the US led to
be one of the longest and deepest recessions in the country. It also created a contagion
effect to other real estate markets which are mostly from European countries and to the
stocks and foreign exchange markets which are heavily linked to the US. This crisis having
a wide scope of affected market from different countries became known as the Global

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Financial Crisis of 2007. The repercussions from the GFC was also thought to be the source
for the ongoing debt crisis in the Eurozone, mostly in Greece (Brunnermeier and Oehmke
2012).

C. Determinants of Exchange Rates

Generally, market prices are thought to be explained by fundamental values, as

consistent with the Efficient Market Hypothesis (EMH) of Fama (1970). The EMH states
that market prices, through the actions of rational market agents, should reflect all
information about its fundamental value. Thus, exchange rates are thought to be
fundamentally explainable by money supply, aggregate output, inflation rate and interest
rate. However, this theory is heavily challenged by the existence of bubbles as its evidence
are drawn from the deviation between assets fundamental and market value. Many
researches have also emerged to either reject efficient market models or provide alternative
pricing models. Grossman and Stiglitz (1980) argue that price system includes information
asymmetry between traders, challenging Famas use of general equilibrium to determine
market prices. Dornbusch in 1976 concluded that there is volatility in the nominal exchange
rate because of overshooting that accounts to the different adjustment length needed by
markets due to sticky prices. Meese and Rogoff (1983), by comparing the forecasting
abilities of different models for exchange rates, found that the exchange rate follows a
martingale process and thus, a random walk model performs better than any other structural
models such as the flexible-price and sticky-price model. Engel and West (2005) also found
that fundamental variables such as money supply, aggregate output, interest rate and
inflation, are insufficient to determine exchange rates. Interestingly however, Engel and
West (2005) found evidence of Granger-causality in foreign exchange to fundamental
values in the dollar exchange rates against six other currencies from 1974 to 2001, rather
than fundamental values determining exchange rates. Engel and Hamilton (1990) also
discredited fundamental based models and proposed a Markov-Switching Model. Van
Norden (1996) also proposed a Regime-Switching Model, however, linking it to
speculative bubbles. Van Norden (1996) using Japanese yen, German mark, and Canadian
dollar exchange rates from 1977 to 1991 tested for evidence of speculative bubbles by
applying a two-state model. The study concluded that exchange rates are sensitive to

10
measurements thus, it did not find consistent evidence of bubbles. Panopoulou and
Pantelidis (2015) extending Van Nordens Regime Switching model, applied a two-state
and three-state model with exchange rate as a function of the bubble size and the known
early warning signal indicators in exchange rate: Exports, Imports, International Reserve,
Interest Rate. The result was that regime-switching models outperform random walk
models for forecasting.

D. Tests used in Determing Bubbles

Asset bubbles are widely accepted to precede a crash or a shift in regime, a scenario
evidenced by multiple financial crises and turning points in the past. However, given that
its literature still remains inconclusive on a definitive approach, experts throughout the
years have developed and used various econometric or statistical tools to detect bubbles,
historically and in real time, such as variance bounds tests, specification tests, unit root-
and cointegration tests, generalized or specialized unit root tests backward, supremum,
and generalized sup ADF and logarithmic periodical power law test.

D.1 Variance Bounds Test

Empirical evidence for bubbles are subsequently drawn from extreme volatility in asset
prices, and as this is often a characteristic of stock prices, most early bubble studies are
employed in the stock markets. In 1981, Shiller first formally introduced a methodology to
detect bubbles by studying the volatility of stock prices in the S&Ps Composite Stock
Price Index from 1971 to 1979 and Modified Dow Jones Industrial Average from 1928 to
1979. Using variance bounds test, Shiller (1981) found that annual changes in real stock
prices are five times higher than what the present value suggests. Furthermore, the study
suggested that volatility can be attributed to fundamentally unobservable factors and that
efficient market model fails to explain price deviations. Diba and Grossman (1988)
studying stock prices also arrived on the same conclusion and described rational bubbles
to reflect the dependence of asset prices on a variable that is not part of market fundamental.
Though this statement is hardly criticized that price bubbles arise from fundamentally

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unobservable factors variance bounds test however, provides little power when it comes
to detecting a bubble.

In 1980, Flood and Garber using the German hyperinflation in 1920 to 1923 tested for
bubbles in currency for the first time. However, the study did not find any significant
evidence of bubbles and concluded that the hyperinflation was consistent with monetary
models. However, the study was considered to bear shortcomings mainly because they
tested for a deterministic bubble that grows at the rate of the interest rate and explodes over
time which is unrealistic as price rises without bounds in real economy (Wu 1995).

Blanchard and Watson (1983) also employed tests on variance bounds of the
distribution of excess returns where a bubble component, if present, will have distribution
of fat tails. Using weekly prices of gold from 1975 to 1981, Blanchard and West found
inconclusive results for both tests, suggesting that lack of runs, unless there were no
bubbles, are either long or short lived, while the fat tail may indicate very leptokurtic
market fundaments or a presence of bubbles.

D.2 Specification Test

In 1987, West applied a different methodology, a specification test, to identify presence

of bubbles and found significant evidence in the stock market. The test compared two sets
of parameters estimates to calculate expected present discounted value (PDV) conditional
to current and past dividends, rejecting the null hypothesis of no bubbles when it is
different. Using the same specification test, Meese (1986) reported evidence of bubbles,
however, this time in the foreign exchange. Meese (1986) tested for evidence of bubbles
or extraneous variables in exchange rate markets using a monthly monetary model of the
dollar/deutsche mark and the dollar/pound exchange rates. The bubbles found in the study
however, found no link to extraordinary events such as the hyperinflation. Thus, Meese
suggested that future works exploit the sensitivity in various forms of model
misspecification, given a more fined tuned sample data. West (1987) using the same
volatility test also applied it to the foreign exchange market, however, found otherwise,
and suggested that Meeses conclusion of exchange rate bubbles may be premature.

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Instead, West attributed the variability to monetary shocks and deviations from purchasing
power parity. Woo (1987) however, using a different model, an estimation version of
portfolio-balance model found evidence of bubbles post the Bretton Wood period.

Coming to a different conclusion and approach, however is Wu (1995), criticizing

specifically Meese and West methodology of a joint null hypothesis of no bubble and
correct model specification, stating that the rejection of the null hypothesis can be mistaken
as evidence of a bubble given that it can be rejected easily for any misspecification of
model or fundamental process. Wu (1995) using Kalman filter technique found no
significant evidence of bubbles in the exchange rates of US dollar against the British pound,
Japanese yen, and the Deutsche mark, contradicting the belief that speculative bubble is
driving the dollar exchange rates in the post-Bretton Woods period.

D.3 Unit Root Test

Though evidence of bubbles is drawn from the deviation of prices from its
fundamentals, the distinction between an exponentially growing fundamental value and
bubble limits the ex-ante analysis of early developed econometric tools. Nevertheless,
present development of new methodologies focuses on identifying a bubble in its
inflationary phase, before it burst or transpire into another financial crisis. A commonly
employed method to identify deviation of asset prices to its fundamentals is the unit root
test. Campbell and Shiller (1987) first suggested the use of unit root test and cointegration
test in a vector autoregressive model of fundamental value and asset price, to detect the
presence of a bubbles.

Using U.S. data for bonds from 1959 to 1983 and stock index from 1871 to 1986, the
authors concluded that the present value model is statistically rejected, with bonds and
stocks indicating transitory deviations that is sensitive to assumed discount rates. However,
these test types have little power to identify periodically collapsing bubbles because of its
nonlinear structure which voids the co-integration tests (Evans, 1991). Hall et al (1999),
thus proposed a generalized ADF test which uses a Markov Regime-Switching Model that
uses the explosive autoregressive root identity to address the limitation of a unit root test

13
without using a cointegration test as suggested by Campbell and Shiller (1987). However,
this model may fail to identify bubbles when explosiveness is not significant in price
volatility (Hall et al 1999). Simulation work from Shi (2012) also reveals that the Markov
switching model is susceptible to false detection or spurious explosiveness and is sensitive
to specifications.

D.4 Recursive Unit Root Test

In 2011, another significant variant of unit root test was developed. Phillips, Wu, and
Yu (PWY) launched the concept of Supremum ADF (SADF) test. The SADF test relies on
repeated estimation of the ADF model on a forward expanding sequence which detects
exuberance in asset prices during its inflationary phase and identifies origination and
termination dates. PWY (2011) provided an empirical application to NASDAQ, in
reference of former Fed chairman Alan Greenspan suspicion of irrational exuberance in
December 1996. The study detected price exuberance and date-stamped the originating
period in mid-1995, peaking in February 2000, and terminating between September and
March 2001, which coincide with the historically known dotcom or tech bubble. The test
proposed by Phillips et al (2011) was further employed in large set of literatures such as
those produced by Homm and Breitung (2012), Harvey, Leybourne, and Sollis (2014,
2015), and Bettendorf and Chen (2013).

Homm and Breitung (2012) provided quite an extensive review of the SADF test in
comparison to other econometric tests Bhargava statistics, modified Busetti Taylor
statistic, modified Kim statistic, and its suggested Chow-type Dickey Fuller (DFC) test
that adapted the same recursive feature. Using NASDAQ stock prices from 1975 to 2000,
Homm and Breitung (2012) concluded that the PWY test, modified Busetti Taylor statistic,
and its DFC all rejected the null of no bubble. Homm and Breitung (2012) further provided
empirical applications using the SADF test, modified Busetti Taylor, and DFC test, in
various platforms to account for historically known speculated bubbles and crises. The
study showed strong evidence of explosive phases in house, land, and stock prices,
conforming to various crises in the US, UK, Spain, Japan, and China. However, it did not
find commodity bubbles in oil and gold prices. Overall, Homm and Breitung (2012)

14
concluded that the PWY test was the most powerful when detecting multiple bubbles.
Another interesting finding of Homm and Breitung however, is that frequency of data
determines robustness for break estimate dates. Moreover, conferring to Shiller and Perron
(1985), expanding the span of sample, more than the frequency, increases the power of unit
root tests (as cited in Homm and Breitung 2012).

Harvey et al (2015) followed Homm and Breitung (2012, HB) comparative study and
employed both the SADF test and HB test of a backward recursive Chow-type ADF in the
NASDAQ index. The study found that both tests are sensitive to the timing of the bubbles
in the sample space, specifically, the SADF test is better suited on early to middle occurring
explosive regimes while the HB test on the explosive regimes towards the end. Thus,
Harvey et al (2015) proposed a joint null of both test that will attain power depending to
the specification of the explosive regime. Harvey et al (2014), applying both SADF test
and bootstrap approach in crude oil and metal prices, concluded that bootstrap SADF test
provides size control under unconditional volatility and does not lose power, while standard
SADF test, assuming stationary unconditional volatility, tends to overstate the occurrence
of speculative bubbles in commodity prices (Harvey et al. 2014).

Bettendorf and Chen (2013) on the other hand, applied SADF test on the exchange rates
between the Sterling and Dollars. The study concluded that there are no bubbles in the real
exchange rates despite rejecting the null of no explosive behavior at 1 percent for SADF
because traded goods, in the form of Producer Price Index (PPI) also rejects the null
hypothesis of no bubbles, converging to the thoughts of Engel (1999) that relative prices
of traded goods explain most movements in exchange rates.

D.5 Rolling Window Unit Root Test

Because multiple or periodically collapsing bubbles include nonlinear structure within

the multiple breaks that produce the bubble phenomena i.e., bubble origination and
termination estimation, and bubble identification, is more complex rather than a single
bubble structured model. Multiple breaks typically diminish the discriminatory power of
existing mechanisms such as the recursive tests given in PWY (Evans 1991; Phillips, Shi

15
and Yu 2014a). Phillips et al (2014a PSY) responding to the PWY limitation SADF test
is considered to have reduced power and inconsistencies with sample periods including
multiple episodes of exuberance and collapse extended its model by allowing for
flexibility in window widths. Phillips et al (2014a) suggested an alternative approach i.e.,
the generalized supremum ADF (GSADF) test which relies on recursive right-tailed ADF
tests but uses flexible window widths in the recursive regressions. Phillips et al (2014a)
also proposed for a backward supremum ADF (BSADF) test as an origination and
termination dates estimation procedure to address the problem of incorporating multiple
bubble structure in one sample space. Phillips et al (2014a) conducted a comparative
application of their PSY test against PWY and CUSUM dating procedures on S&P 500
stock market data from January 1871 to December 2010. The PSY test GSADF and
BSADF test successfully identified well-known historical exuberance and collapse while
the PWY test and CUSUM detects fewer episodes.

Handful of statistical software, with the recent and constant development of

econometric tools, have provided easier tests application and interference. Caspi (2013)
using RTADF (Right Tail Augmented Dickey-Fuller) in Eviews, implemented four test
types Standard ADF, rolling ADF, SADF, and GSADF and concluded that while SADF
test can detect at least one bubble in the S&P 500 price index, GSADF test provided better
results (Caspi 2013). Phillips and Shi (2014) also proposed an alternative algorithm which
allowed the accounting of different collapse period while also accounting market recovery.
Phillips and Shi (2014) applied it in NASDAQ stock market over 1973 to 2013 and
concluded that the dotcom bubble imploded in February 2000 and that market recovery
took place in November 2000 with further market correction until 2004.

D.6 Logarithmic Periodic Power Law Models

Another perspective to bubble identification and forecasting is the Log Periodic Power
Law. The use of LPPL for model calibration, was formally introduced in the paper of
Johansen, Ledoit, and Sornette (2000), and since then, has been in a long series of journals.
The LPPL model assumes the presence of two types of agents: rational and the so called
noise traders, irrational agents with herding behaviors, as commonly discussed in

16
behavioral economics (Sornette and Andersen 2002, Geraskin and Fantazzini 2014). When
the group of irrational agents with herding behavior in large proportions assumes the same
short position, a tendency of a financial bubble developing until a certain critical time, in
turn, causes a crash (Johansen, Ledoit and Sornette 2000).

The use of LPPL for bubble model calibration has been constantly reformed and
generalized by various experts, considerably by Sornette and Zhou (2006) incorporating
fundamental factors (interest rates, spreads, volatility, and exchange rate) to herding
behaviors. Lin et al (2009) provided one of the more sophisticated LPPL model with mean-
reverting residuals. Jiang et al. (2010) using the generalized LPPL model with mean
reverting residuals of Lin et al (2009), investigated two Chinese stock exchange market
indices, the Shanghai Stock Exchange Composite (SSEC) and the Shenzhen Stock
Composite (SZSC) between 2005 to 2009. Results showed that there were two significant
collapses for both samples. Selecting the highest peak, they date stamped the peak dates to
be October 16, 2007 for SSEC, and October 2007 for SZSC.

The LPPL model however, while providing sophisticated approach given its
complexity, has received many criticisms. The most detailed criticism was from Chang and
Feigenbaum (2006). The authors tested the mechanisms underlying the LPPL model using
Bayesian methods and showed that a null hypothesis without the log-periodic structure,
outperforms the JLS model. Chang and Feigenbaum (2006) found that the marginal
likelihood remains basically the same, both the LPPL specication in the mean function
and the model with only the drift term . However, this was later answered by Lin et al
(2009), pointing out that the Bayesian approach to hypothesis testing uses a smoothing
approach in the marginal likelihood and assumes some kind of ergodicity on the sample
and that it has to be sufficiently large. Though the use of LPPL model projects a promising
lead to bubble detection and forecasting through real-time data, experts consider the
methodology to be highly sensitive specification errors.

Despite the literature of asset bubbles being substantially large, involving various fields
and approaches, the methodology and its specific approach remains inconclusive on the
right concepts and frameworks to be taken in consideration. As Gurkaynak (2008)

17
concluded, there is at least one paper that would contradict the results of an econometric
test for asset bubbles, and that it could be indistinguishable from its time-varying
fundamentals. Notwithstanding this, detection and forecasting of bubble episodes using
real-time data still remains to be the focused of recent studies and will still remain to bear
great importance to explaining historical crises and forthcoming ones.

18
 CHAPTER III
FRAMEWORK

According to the Efficient Market Hypothesis (EMH) of Fama (1970), given the
rational behavior and rational expectation of market agents, an asset should be priced
according to its fundamental value which given that all information is available, should be
reflected in the current and future dividends of assets. However, this theory is heavily
challenged by the existence of bubbles as its evidences are drawn from the substantial
deviation between asset prices and its fundamental value. An intuitive description of a
bubble involves a rapid increase in asset prices that is not realistically sustainable in the
long run and thus is expected to subsequently fall at a certain collapse period. Kindleberger
and Aliber (2005) described it to be a sharp increase in asset prices that attracts buyers and
traders because of the expectation that prices will further rise. Former Fed chairman Alan
Greenspan in 1996 described the case of dramatic price run ups in NASDAQ during the
1990s as an irrational exuberance. Wu (1995) while admitting that bubbles cause
discrepancies in price movements however, warns that these are not necessarily evidence
of irrationality. Alan Greenspan in 2002 also reiterated the complexity attached to bubbles,
stating that despite suspicions, its existence can only be confirmed after it burst (The
Federal Reserve Board 2002). As the theoretical existence of bubbles remain to be an
ongoing universal debate in the literature, the explosive or mildly explosive behavior of
asset prices remain to be the primary indicator of market exuberance during an inflationary
phase of a bubble.

The common notion in the literature of bubbles is that when market fundamental
values cannot fully explain the market price, a bubble can be suspected. Realistically,
however, market prices are not really wholly reliant on fundamental variables. Some
researchers attest the market fundamentals lack of explanatory to the market price as a
bubble component while others simply call it the unobservable variable. Given that the
academe provided different approaches, the existence of a bubble remains yet to be
exclusively defined and thus contributing papers such as this require a comprehensive
discussion, nonetheless understanding, to a pricing model and bubble definition as to
what entails, spurs, and bursts a bubble to be taken in context. Despite a variety of pricing

19
models, methodological approaches in bubbles revolve mainly on two specifications, first,
quantifying bubbles as the difference between market price and market fundamental value,
and second, quantifying bubble as a state of an asset. The most employed models in the
literature includes the Rational Bubbles, Heterogenous Belief Bubbles, and the Behavioral
Bubbles.

A. Rational Bubbles

The most employed model approach in the literature is the concept of rational
bubbles. It is first expressed by Blanchard and Watson in 1983 where it defined bubbles as
movements in prices, specifically a rapid increase followed by a burst or sharp decline that
is not justified by available information. Asset prices, according to Blanchard and Watson
(1983) can be decomposed to two components, the fundamental value and an unobservable
component i.e., a bubble, which if present causes irrationality in variance bounds.
Considering risk averse agents, prices are expected to grow at a faster rate to compensate
large risk involved. This model however, does not assume mass irrationality of market
participants but information asymmetry between agents that cause different perceptions on
fundamental values and consequently, form bubbles. Froot and Obstfeld (1989), following
Blanchard and Watsons model of rational bubbles, suggested that the bubble component
should be dependent on cash flows rather than time since bubbles are impossible to be
present at infinite time. Froot and Obstfeld (1989) thus conformed a different model called
intrinsic bubbles which depend on exogeneous factors to the fundamentals. Thus,
intrinsic bubbles are deterministic functions of fundamental, which suggest that stable or
highly persistent fundamentals lead to overvaluation or undervaluation of prices. Delong
et al (1990) on the other hand, suggested that there is another class of participants beside
rational traders the behavioral feedback market participants who base their actions
depending on the previous trade made by other participants, in this case, the rational
traders, thus driving prices higher as a consequence. According to Delong et al (1990) this
interaction begets extreme price increases (or decreases) thus creating the bubbles
(negative bubbles).

20
B. Heterogeneous Beliefs Bubbles

Contrarily, heterogeneous beliefs bubbles of Harrison and Kreps (1978) claims that
bubbles, aside from agents having different opinions on fundamental values, can also arise
from participants willingness to pay at a higher price than market value due to an
optimistic expectation of profiting on the asset in the future, thus a short position of buying
and selling. Instead of mimicking other behaviors of market agents, traders try to predict
bubble episodes and gain from its inflationary phase. Thus, market participants will ride
the bubble and push the prices to increase further, in an effort to make a profit out of it.
This approach does not require aggregate actions from participants, like the rational
bubbles and other models, since bubble component built upon the distortion of prices
increases as investors take fluctuating beliefs through time. However, participants do not
converge on the same expectation and idea of when a bubble will start, thus, risking
investments due to the unknown burst and collapse period of the bubble. This concept
further disproves efficient market models in asset prices and implies that market cannot
prevent mispricing and imbalances given the participation of irrational agents and rational
agents who are trying to gain profits.

C. Behavioral Bubbles

Market bubbles can be tightly associated to market imperfections such in the case of
information asymmetry and price distortions in the Rational Bubbles Model and
Heterogeneous Belief Bubbles Model which lead to market behaviors like herding,
optimism, and overreaction, which are also known as attributes of behavioral finance, a
concept first introduced by Shiller in 1998. Studies on behavioral finance gain popularity
as psychological biases play an important role in market agents behavior and strategy
towards investing. Shiller (2002) highlighted these biases and cited that these stimulates
formation of behavioral bubbles through participants having feedback loops, increasing
price initially by creating enthusiasm or optimism in new factors such as technology
innovations. Hens and Schenk-Hoppe (2004) stated that agents have heterogeneous beliefs
and are often competing for market capitals. Lux (1995) suggested that market participants
can be divided into two based on their strategies, those who base decisions on the opinion

21
of other participants, and those who base their actions on the difference of fundamental
values to an asset price.

Despite the differences between the three most employed models in the literature of
bubbles, the Rational Bubbles, Heterogeneous Belief Bubbles, and Behavioral Bubbles, all
depends on the explosive or mildly explosive behavior of prices that are either
fundamentally unexplainable or driven by market participants goal of profiting. In order
to determine the deviation of nominal exchange rate against its fundamentally determined
value, it is of great importance to provide for an Exchange Rate Determination Model.

D. Exchange Rate Determination Model

In the context of exchange rate models, the most widely used are the monetary model,
the Mundell-Fleming model, the Dornbusch overshooting model, and the portfolio balance
model. However, this study will follow the suggestion of Obstfeld and Rogoff (1996) of
treating exchange rate as an asset price. Thus, assuming that a transversality condition hold
a condition requiring the state variables to converge to zero as time approaches infinity
nominal exchange rate should only be determined by the current and expected values of
the fundamentals. If the transversality condition does not hold and the nominal exchange
rate cannot be explained by its current and expected fundamental values, the nominal
exchange rate may then be subjected to an explosive rational bubble. Van Norden (1996)
defines general model of exchange rate determination as having a bubble specification.
Following Panopoulou and Pantelidis (2015) and Virviescas (2016), any model of
exchange rate determination can be used to estimate the bubble size, which in this study is
understood to be the deviation of the logarithm of the nominal exchange rate from its
fundamental. The fundamental value employed in this study followed the concept of the
Purchasing Power Parity (PPP) where relationship between the nominal exchange rate and
the relative prices are established and expressed in logarithm terms. Exchange rate is then
expressed as:

= 0 + 1 + (1)

22
 Using the definition provided by Kindleberger and Aliber (2005), a bubble is a
systematic deviation of asset prices from its fundamental value. Thus, the residual from
the exchange rate determination equation (1) will be understood in this study as the bubble
component and can also be expressed as:

= , (2)

where still represent the nominal exchange rate, represents the fundamental
value, and is the bubble component. The fundamental component of the nominal
exchange rate is expressed as the price differential between a domestic price index and a
foreign price index:

= (3)

where is the log level of domestic price index and is the log level of foreign price
index.4 The decomposition of nominal exchange rate between fundamental value and
bubble component, aside from bringing theoretical importance to our determination of the
existence of bubbles, are also widely accepted in the foreign exchange literature. Meese
and Rogoff (1983), Engel and Hamilton (1990) and Cheung et al (2005) all argue that
market fundamentals such as money supplies, outputs, interest rates, and inflation fail
to determine exchange rates. Specifically, the former suggested that exchange rate follows
a random walk process, Engel and Hamilton (1990), discrediting fundamental based
models, proposed a Markov-Switching Model, while Cheung et al (2005) concluded that
no actual model has been successful in forecasting exchange rate, claiming that model
specifications are sensitive to the periods used in sampling. Van Norden (1996) also
proposed an alternative solution and linked speculative bubbles to a two Regime-Switching
model.

Following the approach of Van Norden (1996), this study used a two regime-switching
model of exchange rate that includes one explanatory variable taken from the Early

4
Asterisks-denoted variables are representation of foreign counterparts.

23
Warning Signals theory. The indicator variables used in this paper are Exports, Imports,
International Reserves, and Interest Rates. The two proposed regimes are:

Survive: state in which the asset price grows with explosive expectation.
Collapse: state in which the asset price does not have any explosive expectations,
and therefore, reverses to fundamental values.

E. Conceptual Framework

Figure 1 illustrates the conceptual framework this study has employed to determine and
evaluate the existence of bubbles in the Philippine Peso-US Dollar exchange rate. The
nominal exchange rate is evaluated under a normal regime and for an explosive behavior.
The explosive behavior will then be the bubble component which is measured as the
residual of the regression equation of the exchange rate from its fundamental variable.
Consequently, the bubble measure should reflect the pattern of movements in the exchange
rate. The growth of exchange rate is then classified between two states: Collapse and
Survive. The Collapsing probability of the exchange rate is taken as the function of the
bubble size and one of the early warning indicators: Exports, Imports, International
Reserves, and Interest Rates.

Nominal Exchange Rate

(PHP/USD)

Normal Regime Explosive Behavior

Collapse Regime Survive Regime

Early Warning Signal (EWS) Indicators:

Exports, Imports, International Reserves, Interest Rates

No probability of Probability of
Bubble Burst Bubble Burst
(No Collapse) (Collapse)

Figure 1. Conceptual Framework for Bubbles in Exchange Rate.

24
F. Analytical Framework

Figure 2 illustrates the analytical framework of this study. Significant explosive

behavior in the PHP/USD exchange rate is identified using the Generalized Supremum
Augmented Dickey Fuller (GSADF) test. The explosive behavior is taken as an evidence
of the bubble component in the exchange rate. The bubble component is then measured as
the residual of the ordinary least square (OLS) regression of the exchange rate and its
fundamental value. The state of exchange rate is divided into two states, the Surviving and
Collapsing regime. The probability of Collapse is computed as the function of the bubble
size and one of its explanatory variables as proposed for early warning indicators of crises.

Nominal Exchange Rate

(PHP/USD)

GSADF TEST
Identification of
bubble presence

Significant? No. Significant? Yes.

(Do not exhibit (Do exhibit explosive
explosive behavior) behavior)

Bubble Measure

Probability of Probability of
no Collapse a Collapse

Figure 2. Analytical Framework for Exchange Rate Bubbles.

25
 CHAPTER IV
METHODOLOGY

This study used the recursive right-sided unit root test and date-stamping strategy
proposed by Phillips et al (2014a) in the PHP/USD exchange rate. The generalized
supremum ADF (GSADF) test is a recursive right-tailed ADF test that uses flexible
window widths in its recursive regressions to detect multiple episodes of exuberance and
collapse in long historical data. The backward supremum ADF test, on the other hand, is a
date-stamping strategy that also operates on flexible window recursions. After identifying
the presence of exchange rate exuberance, the bubble size is measured through the residual
of the regression of the exchange rate and its fundamental variable. Exchange rate is then
modeled under a Regime-Switching Model where the bubble component can either be in a
Surviving or Collapsing state. The probability of collapse in the exchange rate is computed
as the function of the bubble size and one of the early warning indicators.

A. Identifying Speculative Bubbles

A.1 Rolling Window Test

Following the methodology developed by Phillips et al (2014a), the generalized

supremum ADF (GSADF) test is a procedure based on ADF-type regressions using rolling
estimation windows of different sizes, which could identify distinct exuberant behavior
from the observations and identify bubbles. The ADF regression model for a rolling sample
is written as:

= 1 ,2 + 1, 2 1 + =1 1, 2 1 + (4)

Where is the log nominal exchange rate at t, 1 is the log nominal exchange rate
at t-1, is the log difference of the nominal exchange rate at t and t-1, is the lag-order,
is the autoregressive coefficient, (for i=1k) are the coefficients of the lagged first
difference and ~(0, 21 ,2 ). The null hypothesis that will be tested in this study follows
Phillips et al (2014ab) which allows for a martingale process or specifically, assumes a

26
random walk process with asymptotically negligible drift to capture mild drift in exchange
rates that are realistic over long historical periods. The model is written as:

= + 1 + , (5)

where is a constant, is the sample size, is a localizing coefficient that controls the
magnitude of the intercept and drift as and which should be relatively small as
reflected in financial time series, and ~ (0, 2 ).5 This equation is a unit root
procedure without a trend item6, but with a gradually disappearing intercept. Traditionally,
eq. (5) is used to test the null hypothesis of a unit root against the alternative of stationarity.
For this study, the same equation will be carried out to test for a mildly explosive root,
except that the alternative requires >1 to test for an explosive behavior, instead of the
traditional alternative condition of =1. Formally, the tests are:

Ho : =1 (6)
Ha : >1 (7)

rw=r2-r1 r2
r2
r1 r2
rw=r2-r1 r2
r1 r1 r2
r2
rw=r2-r1 r2
r1
r2

Figure 3. Sample sequence and window width of GSADF test.

Equation (4) is estimated repeatedly using subsets of the sample data with being the
(fractional) window size of regression. The starting point is given by the fraction 1 of the
total number of observation and varies from 0 to 2 0 , the ending point is given by the

5
PSY (2014) set d, and to unity (1); imposing >1/2 makes the drift smaller in value
6
Root procedure that follows a random walk process

27
fraction 2 and varies from 0 to 1, while = 2 1. Figure 3 provides an illustration of
sample sequences and window width given a sample interval of [0,1]. The smallest sample
window width fraction 0 needs to be large enough to allow initial estimation but not too
large enough to miss early bubble period. As suggested by Phillips et al (2014ab), 0 can
be computed as:

1.8
= 0.01 + (8)

where is the number of observations. Phillips et al (2014ab) recommended this rule

as it ensures that is large enough for an adequate initial estimation, yet small enough so
that the test does not miss any opportunity to detect early explosive episodes. The choice
of the lag length is also crucial. If the lag order is over-specied, then the size distortion
would be more severe.

The GSADF test uses the idea of repeatedly running the ADF test regression (4) in a
recursive fashion, on subsamples of data. The test allows the starting point r1, to vary within
the range [0, r2-r0] and the size of the window width, rw, to flexibly shifts within the bounds
of r1 and r2. Specifically, the GSADF test is defined as:

GSADF (r0) = sup {12 } (9)
r2 [r0, 1]
r1 [0, r2 r0]

A.2 Date-stamping Strategy

According to Phillips et al (2014a), GSADF procedure can also be used as a date-

stamping strategy that will consistently estimate the origination and termination date of a
bubble when the null hypothesis is rejected. Specifically, the BSADF test performs a
supremum ADF test on a backward expanding sample sequence where the end point of
each sample, 2 is fixed and the starting point 1 allowed to vary from 0 to 2 0 . Figure
4 illustrates a sample sequence of the backward sup ADF test that uses a fixed termination
[1 2 ] with 1 varying from 0 to 2 0 .

28
 rw=r2-r1
r1
r1 r2
r1

Figure 4. Sample Sequence for Backward Sup ADF test.

The corresponding BSADF statistic is defined as the supremum value of the ADF
statistic sequence and will be denoted as 2 (0 ). The estimated origination point of
a bubble will be the first chronological observation, , in which 2 (0 ) crosses the
corresponding critical value of the backward supremum ADF statistic above, while the
estimated termination point will be the first chronological observation denoted as , in

which the 2 (0 ) crosses the critical value again, however, this time below. The
fractional origination and termination points are determined according to the following
crossing time relative to the critical values:

= inf {2 2 (0 ) > 2 2 } (10)
2 [0 ,1]

= inf {2 2 (0 ) < 2 2 } (11)
2 [ ,1]

where 2 2 is the 100(1- T)% critical value of the supremum ADF statistic based
on [2 ] observations. BSADF (r0) for r2 [r0, 1], is the backward supremum ADF statistic
that relates to the GSADF statistic by noting that:

GSADF (r0) = sup {2 (0 )} (12)

r2 [r0, 1]

A.3 Monte Carlo Simulation for Critical Values

To construct the critical values to evaluate the BSADF statistics for the date stamping
strategy, the first step is to simulate a time series process, , under the null model of no

29
bubbles given in (5). Under the null hypothesis, all parameters are fixed, thus, following
Phillips et al (2014b) and also for simplicity, the parameters are set to unity, = = 1.7
Using the simulated time series process from null model in (1), the second step is to run
the ADF regression model, with equal to zero:

() () ()
= + 1 + (13)

()
Where is a constant, and ~(0, 2 ) for different window fractions8 of the total
sample, as determined by and as illustrated in figure 1. The model can be run with a
fixed ending point 2 and a varying starting point 1, then the same procedure can be
repeated for all values of 2 . After that, only the largest value of test statistic for each ending
point 2 is stored and then compared to other critical values. The largest critical value will
then be taken as the overall critical value of the GSADF test. This will be repeated for a
simulation of M=1000 times since both GSADF and BSADF test have nonstandard

distributions and depends on sample sizes. Lastly, the critical value 2 2 for a given
point in the time series data sample [2 ] and for a given significance level of 1 is
calculated as the 100 percentile of the M simulated values. Likewise, the critical values
for overall bubble test, which will be compared to the GSADF statistics is calculated as the
100 percentile of all M values of GSADF.

B. Bubble Measures

Once the bubble has been identified and confirmed through the GSADF test, it is
important to determine how big or how important it is. Using the definition provided by
Kindleberger and Aliber (2005), a bubble is a systematic deviation of asset prices from its
fundamental value. Following Panopoulou and Pantelidis (2015) and Virviescas (2016),
any model of exchange rate determination can be used to estimate the bubble size, which
in this study is understood to be the deviation of the logarithm of the nominal exchange

7
By setting the parameters to unity, the finite sample distribution will almost be invariant to and
relatively to the drift in (2) which is empirically realistic as prices tend to have a small drift in normal
regime
8
th is given as the nth number of simulation, m=1,2,3,4,5M (simulation M=1000)

30
rate from its fundamental value, or as defined in equation (2). Thus, equation (2) will be
used to measure the size of the bubble in the PHP/USD exchange rate. The measure that is
employed in this study uses the concept of the Purchasing Power Parity (PPP) where the
relationship between the nominal exchange rate and the relative prices expressed are
established and expressed in logarithm terms. Exchange rate is then expressed as:

= 0 + 1 + , (14)

Where is defined as the fundamental price as expressed in equation (3), and , as

the deviation from fundamental prices given by the residual of equation (14).

C. Regime-Switching Model

The Regime-Switching model developed by Engel and Hamilton (1990) is the most
used approach to the empirical analysis of currency crises since it allows the identification
of multiple states of the time series and its transition. In the currency market, this model
also allows the modeling of the likelihood of devaluation or appreciation of the currency.
In this model, the bubble component of the exchange rate may be in two regimes, the
Survival (S) or the Collapse (C). In the Survival regime, the bubble appears and grows
while in the collapse regime, the bubble disappears and exchange rate reverses to
fundamental variables. The study employed an extension of the Van Norden and Schallers
Model, and as one of the models used in Brooks and Katsaris (2005), Panopoulou and
Pantelidis (2015), and Virviescas (2016). The extension uses one of the variables proposed
in the EWS model as a function of the probability of an exchange rate to collapse. The
study included four different early warning indicators that can act as a signal of changing
market expectations about the speculative bubble. The four variables are: Exports, Imports,
International Reserves, and Interest Rates. The equations are the following:

Collapse Equation: ,+1 = 0 + 1 + 2 (, , (15)

, ) + ,+1

where, ,+1 ~(0, 2 )

31
 Survive Equation: ,+1 = 0 + 1 + 2 (, , (16)
, ) + ,+1

where, ,+1 ~(0, 2 )

Probability Equation: Pr(+1 = ) = = F(0 + 1 + 2 ), (17)

where first difference of the logarithm of exchange rate and the representation of
the gross return to the exchange rate, is the bubble measure, and Exports, Imports,
International Reserve and Interest Rate are the four early warning signal indicators. The
probability of collapse is bounded between 0 and 1 and is equal to the cumulative density
function of the standard normal distribution.

D. Data

The sample data employed in this study spans on the historical data of the monthly, end
of period, exchange rate between the Philippine Peso (PHP) and the US Dollar (USD) from
1993 to 2016. The fundamental variable was proxied by the Consumer Price Index (CPI)
of both countries, and the four early warning indicators for the domestic country
Philippines, i.e., Exports, Imports, International Reserves, and Interest Rates, are also in
monthly frequency. All data are taken from the International Monetary Fund-International
Financial Statistics (IMF-IFS) data base.

E. Analytical Tools

The necessary statistics were generated through the statistical software Eviews8.
Specifically, the GSADF test and BSADF test are employed from Eviews8 add-in right
tailed augmented dickey fuller (rtadf) uploaded and created by Caspi (2013). The dynamic
ordinary least squares regression (DOLS) and the Regime-Switching model are estimated
through the Eviews8 built-in programs. Graphical representation of results is also
employed through Eviews8.

32
 CHAPTER V
RESULTS AND DISCUSSION

This chapter presents the results and findings of the study based on its objectives. The
first part is the application of the Generalized Augmented Dickey Fuller (GSADF) which
identified presence of speculative bubbles in the Philippine Peso-US Dollar exchange rate.
The second part provided the measurement of the bubble size in the exchange rate. Lastly,
the third part is the estimation of the bubble model and the probability of collapse
associated for each of the fundamental variables identified as early warning signals for
crisis.

Globalization has increased the interconnectedness of different markets all over the
world, allowing for more flexible business and investment trading. However, this new
environment of trade and financial liberalization has exposed economies to foreign
financial disruption, making most financial markets such as stocks and exchange rates
susceptible to volatility and instability for the last three decades. The Philippines,
increasing its international trade participation, is nonetheless vulnerable from financial
disruptions of foreign markets, especially from the US. In fact, most of its business
transactions are done using the PHP/USD quote. Market bubble as a component of
exchange rate as well as a known precursor to financial crises thus, provides an
understanding of exchange rate movements and early warning signals for crisis detection.
Figure 5 illustrate the time series of the logarithm of the PHP/USD exchange rate.

Figure 5. Logarithm of PHP/USD exchange rate, 1993-2016.

33
 Figure 6. Gross Return of PHP/USD exchange rate, 1993-2016.

Figure 6 illustrates the gross return of the PHP/USD exchange rate from 1993 to 2016.
Gross return of the exchange rate is computed as the first difference of the present exchange
rate relative to the past exchange rate. The figure showcases the volatility of the changes
in gross return to PHP/USD exchange rate with noticeable increased disparity during the
1998 and 2001 which are known as crisis periods; the Asian Financial Crisis and the
dotcom crisis, respectively. Movements in exchange rate quotes can influence market
prices and consequently, reflect market instability. Thus, increased volatility in exchange
rate can be used as an indicator of financial bubbles and crises. Table 1 provides the
summary of the descriptive statistics for the PHP/USD exchange rate, as well as its gross
return.

Table 1. Summary Statistics of PHP/USD exchange rate and its gross return, 1993-2016.
PHP/USD Log PHP/USD Gross Return
Observation 288 288 287
Mean 42.894865 3.731037 0.085244
Minimum 23.879000 3.172999 -3.283000
Maximum 56.357000 4.031706 5.320000
Standard Deviation 9.327212 0.245466 0.981908
Skewness -0.664208 -0.975691 1.133948
Kurtosis -0.569074 -0.272373 5.853854

34
 The logarithm of the PHP/USD exchange rate deviates from its mean by 0.245466 and
its gross by 0.981908, thus, indicating high volatility and possibly, the risks associated in
exchange rate trading over time. Observation of excessive kurtosis or leptokurtic
distribution on the gross return sample, on the other hand, indicates non-normal distribution
which is a usual characteristic of financial returns and a signal for the probability of
extreme return outcomes.

A. Identifying and Date-Stamping of Bubble Episodes

Following the approach listed in Chapter IV, the Generalized Augmented Dickey Fuller
(GSADF) test is applied in the PHP/USD exchange rate to identify the existence of a
speculative bubble. Table 2 presents the results of the GSADF test and rejects the null
hypothesis of having no bubble in the exchange rate at 1 percent significance level, thus,
affirming the presence of a speculative bubble in the PHP/USD currency pair for the period
analyzed.

Table 2. GSADF test result.

Log PHP/USD exchange rate t-Statistic Prob
GSADF 3.889756 0.0005
Test critical values: 99% 2.885054
95% 2.176151
90% 1.937145

Since the GSADF test confirmed the existence of bubbles in the log PHP/USD
exchange rate, a dating algorithm is applied to identify the duration and date stamp bubble
episodes. Backward sup ADF (BSADF) test is applied with the critical values as
benchmark points and are generated from Monte Carlo simulations. Bubble episodes are
identified as the period when the statistic lies above the critical value. Thus, the starting
point of the bubble episode is the first chronological observation that crosses above the
corresponding critical value, while the termination point is identified as the first
chronological observation that crosses below the corresponding critical values. Figure 7
shows the result of the BSADF date-stamping procedure of bubble periods for the
PHP/USD exchange rate.

35
 Figure 7. Date-stamping of bubble periods in the PHP/USD exchange rate

The BSADF test date-stamped three bubble periods over the sample period. The first
bubble episode identified in the PHP/USD exchange rate started in August of 1997 lasting
until the October of 1998. This bubble period is attributable to the Asian Financial Crisis
experienced by the Philippines and other Asian countries during the late 1990s. The AFC
was considered to originate in Thailand and was marked when the Thai Baht was allowed
to float against foreign currencies on July of 1997. Referring to the result of the BSADF
test procedure, the bubble was reflected in the Philippines on August of 1997, a month later
after the conferred crisis mark, and ended on October 1998 which is consistent with the
reported stabilization in mid-1998 by the IMF (International Monetary Fund 2000). The
delay in the start of the bubble period may be attributed to the fact that among the countries
affected, Philippines has the least incurred economic loss. According to the IMF, successful
programs of macroeconomic adjustment and structural reforms before the late 1990s due
to the experienced recession in the late 1980s and early 1990s may have helped the
Philippines to overcome the crisis at relatively lower economic loss (International

36
Monetary Fund 2000). Nevertheless, the test still identified the bubble period without
sizable delay bias.

The second bubble identified in Figure 7 is attributable to the dotcom crisis that
originated in the NASDAQ stocks exchange. According to the BSADF test, the bubble
episode was present from July 2000 to February 2002. This bubble period coincides with
the dotcom crisis experienced in the US stocks exchange in 2001. Although the bubble
period is significant, referring to the figure, the BSADF sequence is relatively closed to the
95 percent critical value sequence. Bubbles in stock exchange are relatively short-lived and
since the dotcom crisis originated and prevailed in the stock market the small distance of
the BSADF sequence against the critical value may be justified.

The third bubble identified by the BSADF date-stamping procedure had its
origination date on November of 2006 and ended on May 2008, which lasted for 18 months.
This bubble period can also be attributed to another well-known financial crisis, the global
financial crisis of 2007. This time, the test was able to identify the bubble before the crisis
mark which is considered to be in July of 2007, followed by the collapse of the Lehman
Brothers (LH) bank in August of 2008 (The Economist 2013). Therefore, the GFC bubble
was already reflected in the Philippine Foreign Exchange Market eight months before the
said start of collapse period. Coincidentally, at that period, the peso reached a four-and-a-
half year high of P49.66/USD. Also at the time, the Monetary Board adopted a new tiering
scheme on banks aggregate placements, thus, have encouraged banks to use excess funds
for lending and spur business activity. In the Philippine Stock market, high growth of
capital was also recorded while ranking 2nd in Asia (Bangko Sentral ng Pilipinas 2007).

B. Bubble Measure

Since the presence of a significant explosive behavior in the PHP/USD exchange rate
is confirmed, the bubble component is measured to determine its effect on the movements
in exchange rate. The bubble measure is computed from the ordinary least square (OLS)
residual of the PHP/USD exchange rate relative to the PPP. For this study, only a simple
measure of the bubble component relative to the PHP/USD exchange rate is used since it

37
will be used to model gross return of exchange rates, together with other fundamental
values which are determined to be early warning signals for crisis. Table 3 provides for the
result of the OLS to the determination equation of exchange rate and PPP. Both the constant
and the chosen explanatory variable, the PPP proxy, CPI, is statistically significant at 1
percent.

Table 3. Estimation of Exchange Rate Determination Model, 19932016.

Variable Coefficient Standard Error
Constant 3.880602 0.034084***
PPP 0.998738 0.15097***

Notes: **,*** indicate that the null hypothesis can be rejected at 5%, and 1%
levels respectively

Based on the resulting regression, the residual can be estimated and treated as the
bubble measure. Figure 8 plots the bubble measure against the PHP/USD exchange rate.
The graph shows that the measured bubble exhibits similar behavior to the PHP/USD
exchange rate, while also revealing positive and negative deviations from the explanatory
variable.

4.2

4.0
.6
3.8
.4
3.6
.2
3.4
.0
3.2
-.2
3.0
-.4

-.6
94 96 98 00 02 04 06 08 10 12 14 16

Bubble (Residual)
PHP/USD (Actual)
Fitted

Figure 8. Bubble Measure and Logarithm of PHP/USD exchange rate, 1993-2016.

38
Figure 9, on the other hand, shows the three identified financial crises through the GSADF
test relative to the bubble measure. The three identified crises are the AFC which started
from 1997M08 to 1998M10, the Dotcom Crisis from 2000M10 to 2002M02, and the GFC
from 2006M11 to 2008M05. The three periods, as shaded in Figure 9, experienced relative
positive values of the bubble component of exchange rate with each subsequent collapse
or decrease in size before the identified bubble end period.

1.0 .4
2000M10-2002M02
Dotcom Crisis
.3
0.8
1997M08-1998M10 .2
Asian Financial Crisis

0.6 2006M11-2008M05
Global Financial Crisis
.1

.0
0.4

-.1
0.2
-.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure

Figure 9. Bubble Measure and the identified bubble phenomena in the GSADF test,
1993 2016.

C. Regime-Switching Model of Exchange Rate

The Markov-Switching Model of exchange rate is used to identify multiple states in

the PHP/USD currency pair. This model is often used to explain how the transition from
one state to another occurs, which in the currency markets, allows the modelling of the
likelihood of devaluation or appreciation. In this model, exchange rates can be divided into
two states; the Survive and the Collapse regime. The probability of collapsing is modeled
as a function of both the size of the bubble determined from the OLS residual of the
exchange rate and its fundamental value, and one of the indicators proposed as an early
warning signal for crisis. The model, as presented in Chapter IV, is expressed in the
following equations while Table 4 shows the result estimation from the model.

39
 Collapse Equation: ,+1 = 0 + 1 + 2 (, , (15)
, ) + ,+1

where, ,+1 ~(0, 2 )

Survive Equation: ,+1 = 0 + 1 + 2 (, , (16)

, ) + ,+1

where, ,+1 ~(0, 2 )

Probability Equation: Pr(+1 ) = = F(0 + 1 + 2 ), (17)

Table 4. Estimation result for the Regime-Switching Model of PHP/USD exchange rate.
Exports Imports International Interest Rate
Reserves
0 0.005861 -0.0031441 -0.017968 -0.022598
(0.077883) (0.046213) (0.047781) (0.048020)
1 -0.232300 -0.251479 -0.251150 -0.252111
(0.249169) (0.238322) (0.239987) (0.240128)
2 0.001755 0.005517 -0.004877 0.003617
(0.001069) (0.004950) (0.013256) (0.003407)
0 1.174442 1.129588 1.147878 1.212947
(0.409318)*** (0.395757)*** (0.444873)*** (0.404861)***
1 -5.570349 -5.075353 -4.750869 -5.5126623
(2.468366)** (2.298930)** (2.4097734) (2.271821)**
2 0.004709 -0.013308 -0.074527 -0.023617
(0.011364) (0.025537) (0.097734) (0.011387)**
q0 5.393937 4.394790 2.257785 2.390187
(02.89927) (0.747226)*** (0.850324)*** (0.675155)***
q1 -9.761266 2.140841 0.468581 0.337432
(11.70951) (4.051054) (5.7781481) (2.535382)
Notes: Standard errors are reported in parentheses; **,*** indicate that the null hypothesis can be rejected
at 5%, and 1% levels respectively

40
 Table 4 presents that not all coefficients for the fundamental variables analyzed are
statistically significant. For the Survive Regime, only one intercept for the export yielded
the expected result which is a positive value. Thus, under the survive regime, only the
export gains positive return. All coefficients for the bubble size under the survive regime
1 exhibits negative values. Although this is not the expected sign for the bubble
coefficient, the coefficient is relevant since its value is greater than when the bubble size is
under the collapse regime 1. Since the 1 under the collapse regime, which measures
the relationship of the gross return and the bubble size, all have negative values and
significant for the values of exports and imports, and interest rate, it implies that an increase
in bubble size would create larger loss in the exchange rate return.

On the other hand, in the collapse regime, all intercepts are positive and significant at
1 percent. Thus, under the collapse regime, the gross return to exchange rate experience
positive return with the increasing value of exchange rate when depreciating. The
coefficients for the early warning signal indicators 2 are not significant, except for the
interest rate. Thus, referring to the results yielded in the Regime-Switching model, interest
rate is a good explanatory variable for changes in the gross return of exchange rate.
However, according to Panopoulou and Pantelidis (2015), the explanatory variables which
did not present to be significant, do not automatically imply that it has no predictive power
to exchange rate as some explanatory variables may be better used in out-of-sample than
in-sample analysis. Also, referring to the studies of Panopoulou and Pantelidis (2015) and
(Virviescas 2016), the EWS indicators significances vary across the exchange rate
determination model used. Thus, extension studies are necessary to further analyze the
predictive power of exchange rate fundamental variables.

Nevertheless, analyzing the signs of the coefficient estimates, the international

reserves, imports, and interest rate are inversely related to the gross return of exchange rate.
Thus, significant increase in either reserves, imports, or interest rates is counteracted by a
decrease in the gross return of exchange rate. Given that increase in foreign reserves and
interest rates increases the supply of dollar, consequently if the demand remains relatively
the same, the value of peso increases and appreciates. The appreciation of the peso relative
to the dollar is reflected by a lower value of the PHP/USD exchange rate, thus also lowering

41
the gross return of exchange rate relative to its previous value. For the imports, an increase
in its value would imply an increase in the demand for dollar, thus, also indication the
depreciation of the dollar. For the exports, its coefficient under the collapse regime 2 is
positive. Value of exports is then directly related to the gross return of exchange. Thus,
significant decrease in value of exports and imports imply a decrease in gross return of
exchange rate under a collapse regime. The estimation result for this model is also
computed for the probability of collapse of the bubble under the used early warning
indicators. The probability of a collapse in the currency market can be expressed as:

0 1 2 0 1 2
(+1 < ) = (1 ) ( ) + ( ) (17)

The probability of a crash for each early warning indicator is graphed against the bubble
size. Figures below illustrate whether or not significant bubble phenomena are reflected in
the exchange rate explanatory variables and if it emerged as an indicator for the likeness
of the collapse to happen. Figure 10 shows the estimated probability of a crash relative to
the interest rate and the bubble size. It also shows that there are three periods when a market
collapse is highly likely: around 1997 to 1998, 2000 to 2001, and in 2008. These three
periods coincide with known financial crises: the AFC, the dotcom, and the GFC,
respectively. For the AFC, the signal started on June 1997 and peaked on August 1997.
The dotcom crisis signal for collapse started on June 2000 and peaked on August 2000. For
the GFC, significant probability of collapse before the crisis mark was recorded on June
2006 at around 25 percent. This may be associated with market bubbles which are known
to occur before a crisis transpired or when the bubble already burst. Nevertheless, the
collapse for the GFC was recorded on November of 2007 and peaked on September 2008.

42
 1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Collapse_Interest Rate

Figure 10. Estimated Probability of Collapse relative to Interest Rate and Bubble
Measure, 19932016.

Figure 11 on the other hand plots the bubble measure, probability of collapse, and the
probability of shifting from the surviving state to the collapsing state relative to interest
rate. The figure shows that under the EWS indicator interest rate, the probability of
switching to the collapse regime is small with less than 20 percent of probability. This may
be the reflection of the sensitivity of interest rates which are controlled by the monetary
policy of the central bank rather than the business traders and the external sector of the
market.

43
 1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Switching to State of Collapse
Probability of Collapse

Figure 11. Estimated Probability of Collapse and Regime-Switching to Collapse State

relative to Interest Rate, 19932016.

Figure 12 illustrates the estimated probability of crashing relative to international

reserves. The figure also shows similar pattern of collapsing probability to the interest rate
however, another period was shown with increased probability of collapse during the early
1990s. This probability of collapse maybe reflected because of the capital account
liberalization in 1993 following the series of low growth rates and recession during the
early 1990s because of the post-martial law period and energy crisis at that time. For the
probability of collapse relative to international reserves, the signal for the AFC started on
June 1997 and peaked on August 1997. There is also a recorded relatively small probability
of collapse on July 1999 which could be a warning signal for the dotcom crisis of 2000.
However, based on the estimation under the variable international reserves, the dotcom
crisis can be traced to start its effect on June 2000, and peaked on September 2000 for the
Philippines. Another relatively small probability of collapse was also recorder before the
GFC on June 2006. The GFC however, started to emerged in the Philippines on April 2008
and peaked on September 2008.

44
 1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Collapse_International Reserves

Figure 12. Estimated Probability of Collapse relative to International Reserves and

Bubble Measure, 19932016.

Figure 13 on the other hand plots the bubble measure, probability of collapse, and the
probability of shifting from the surviving state to the collapsing state relative to
international reserves. The figure shows that relative to the interest rate, the EWS indicator
international reserve exhibits higher probability of switching to the collapse regime.
Specifically, high probability of switching to a collapsing state at 42 percent was
substantially shown in 1996 which is the period before the AFC occurred. This suggests
that under the EWS indicator international reserves, the probability of experiencing a crisis
was already reflective. Moreover, the display of the increased probability of collapse early
on relative to the international reserves can also be attributed to the origination of the AFC
which is a currency crisis.

45
 1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Switching to Collapse State
Probability of Collapse

Figure 13. Estimated Probability of Crash and Regime-Switching to Collapse State

relative to International Reserves, 19932016.

Figure 14 plots the EWS indicator value of exports relative to the bubble measure. The
estimation of the probability of collapse relative to the value of exports also shows three
periods of market collapse which coincides with the AFC, Dotcom crisis, and GFC. For
the AFC, the high probability of collapse using the variable export is first observed in April
of 1997, thus providing an early signal of collapse. For the dotcom bubble, it can be
observed that high probability of collapse is recorded as early as August 1998, however,
the probability of collapse did not persist until the July of 2000 and peaked on October of
the same year. The GFC also saw an early rise in the probability of collapse around July
2006. This may be associated with market bubbles which are known to occur before a crisis
transpired or when the bubble already burst. The crisis mark for the GFC according to the
graph started on June 2008 and peaked on October of the same year. Among all indicators,
the traded goods, including exports have provided more indication and evidence of collapse
probability which is in line with the literature as exchange rate movements are thought to

46
be heavily affected by traded goods (Engel 1999). The same is true for the estimation under
the explanatory variable imports which is discussed below.

1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Collapse_Exports

Figure 14. Estimated Probability of Collapse relative to Exports and Bubble

Measure, 19932016.

Figure 15 plots the bubble measure, probability of collapse, and the probability of
shifting from the surviving state to the collapsing state relative to exports. In comparison
to the other EWS indicators, the value of export was shown to be sensitive under switching
regimes especially post the GFC. The probability of switching from the surviving state to
a collapsing state was as high as 83 percent for periods coinciding crisis. Specifically, high
frequency of regime-switching was shown from 1998 to early 2000s and slightly higher
relative probability from 2008 to 2016. These periods concur to periods of high market
volatility with the each of the three financial crises identified coinciding the said periods.
Thus, exports can be considered as a good EWS indicator for financial crises as well as
exchange rate movements.

47
 1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Switching to State of Collapse
Probability of Collapse

Figure 15. Estimated Probability of Crash and Regime-Switching to Collapse State

relative to Exports, 1993 2016.

Figure 16 shows the estimated probability of a crash relative to the fundamental

variable imports and the bubble size. In comparison with the previous figures of the
probability of collapse, Figure 14 also shows three periods of high collapse probability,
each coinciding with known financial crises from the last two decades. The first period
which coincides with the AFC, started in June 1997, a month early from the crisis mark of
July 1997, and peaking on August 1997, which as previously discussed, the month the
GSADF test first recorded the origination of the bubble in the exchange rate. For the
dotcom crisis, the earliest recorded high probability of collapse was on June 2000, peaking
on the same year in September. Also, as with the previous results, it also showed a warning
signal on October of 1999 with a relatively small probability of collapse around 23 percent.
For the periods coinciding the GFC, there are two identified high probability of collapse
recorded. The first signal was on June 2006 however, it was relatively small compared to
the proceeding high probability of collapse recorded in April 2008, which peaked on
September of the same year. Another significant probability of collapse at around 20

48
percent however non-translating to any other crisis, happened on August 2016. Though
small, the probability of collapse recorded in this period may also signal an impeding
market collapse in the future which is consistent with the speculations of another global
crisis and speculation of growing market bubbles in the Philippine asset market via IMF
report (2013). It should also be noted that the last quarter of 2016 closed out with a weak
peso though the BSP described it as only an episodic movement because of the relatively
high dollar demand due to global market turmoil (Business World online 2016).

1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Collapse_Imports

Figure 16. Estimated Probability of Collapse relative to Imports and Bubble

Measure, 19932016.

Figure 17 on the other hand plots the bubble measure, probability of collapse, and the
probability of shifting from the surviving state to the collapsing state relative to imports.
The figure shows that relative to all the other explanatory variable, imports exhibits the
highest sensitivity towards the probability of switching regimes. However, the probability
of switching regimes relative to imports did not indicate observable signals to crises as the
international reserves before the AFC. The probability of collapse was shown rise as high
as 47 percent with observable deviation and spikes between periods of crisis. Moreover,

49
after the GFC, the probability of switching to the collapsing regime relative to imports was
more apparent especially in the year 2014 and onwards. This may be an indication of the
increasing trade liberalization of the Philippines. Thus, for forecasting crises and exchange
rate movements in the proceeding years, it may be useful to closely observe changes in the
growth rate of imports value.

1.4 .4

1.2 .3

1.0 .2

0.8 .1

0.6 .0

0.4 -.1

0.2 -.2

0.0 -.3
94 96 98 00 02 04 06 08 10 12 14 16

Bubble Measure
Probability of Switching to Collapse State
Probability of Collapse

Figure 15. Estimated Probability of Crash and Regime-Switching to Collapse state

relative to Imports, 19932016.

50
 CHAPTER VI
SUMMARY AND CONCLUSION

Despite confusion on its precise identity and function, bubble phenomena have become
relevant in most economic and financial literature as it has found importance by preceding
most financial crises in the past. Its identification and prediction methods are thought to
provide early warning signals to forthcoming crises and to improve monetary responses to
maintain economic stability. The foreign exchange market, being one of the more
prominent financial market in the Philippines exhibited most periods of market instability
for the periods 1993 to 2016.

Bubble studies focusing in the Philippines is scarce and if there are any, it was mostly
in relation to the experienced Asian Financial Crisis back in the late 1990s or as part of a
wide market analysis for a new econometric method. Nevertheless, studies on bubbles are
mostly employed to test ex-post crises with an emphasis on using it later to forecast
forthcoming financial crises. Moreover, bubbles are also thought to be a residual between
the deviation of prices from its fundamental values which arises from market failure such
as information asymmetry between traders (Grossman and Stiglitz 1980). Engel and
Hamilton (1990) also discredited fundamental based models and proposed that market
prices can be modelled under switching regimes. Van Norden (1996) applied a variant of
the regime-switching models to exchange rates and linked the deviation from fundamental
variables to speculative bubbles. This bubble component in exchange rate can be
characterized with explosive growth behavior that exhibit the collapsing probability of
asset prices. Thus, bubble size relative to exchange rates can be used to explain its
movements most especially under financial disruptions or crises.

This property of bubble as a component of exchange rate was used to study its effect
and impact in the PHP/USD exchange rate. Firstly, the study investigated for evidence of
explosive behaviors which characterizes bubbles. Using the GSADF test, the study
investigated for significant explosive behaviors in the PHP/USD exchange rate. The
GSADF test was significant at 1 percent level, confirming the existence of the bubble in
the exchange rate. Significant bubble episodes are date-stamped and was found to be
present on August 1997 until October of 1998, October of 2000 until August of 2001, and

51
on June 2006 until May of 2008. These bubble episodes coincide with the AFC in 1997,
the dotcom crisis in 2001, and the Global Financial Crisis in 2007. The study further
investigated the effect of the bubble component relative to its size in the exchange rate.
Bubble size was computed using the OLS residual of the exchange rate and the Purchasing
Power Parity as its fundamental value. This bubble measure was then modelled as a
function of the gross return of exchange rate together with four exchange rate explanatory
variables which are also known as early warning signal indicators for financial crisis:
Imports, Exports, International Reserves, and Interest Rate.

Evidence of the explanatory power of speculative bubbles in exchange rate movements

was reflected in the model of gross return to exchange rate against the bubble size and each
of the early warning signal indicator. Exports, Imports, International Reserves, and Interest
Rate was shown to exhibit the bubble measure in the exchange rate and was effective in
evaluating the probability of the bubble collapsing or the crisis mark. Thus, all the early
warning signal indicators are shown to mirror exchange rate movements. All EWS
indicators have exhibited the probability of collapse for the three identified financial crises
in the GSADF and BSADF tests. However, despite reflecting the collapsing probability of
the bubble component in the exchange rate, only the interest rate under the collapse regime
is significant. The other three EWS indicators, exports, imports, and international reserves,
did not show significant effects in determining gross return to exchange rate. The non-
significance may be traced back to the conclusion of Engel and West (2005) that it is most
likely that exchange rates Granger-cause its fundamental values rather than the
fundamental values determining exchange rates. Moreover, Panopoulou and Pantelidis
(2015) cited that exchange rate fundamental variables may have better predictive power
when considering out-of-sample analysis.

Despite the non-significance, the explanatory variables are nevertheless consistent with
its established relation to exchange rate appreciation and depreciation. Based on the
Regime-Switching model estimation, International Reserves, Imports and Interest Rates
are inversely related to the gross return of exchange rate, while Exports are directly related
to the gross return of exchange rate. This is consistent with the economic concept that an
increase in the international reserves, imports and interest rates may lead to appreciation,

52
thus lowering the value of exchange rate and the its relative gross return. Moreover, the
bubble component relative to all early warning indicators was shown to be the main driver
of the collapsing probability of exchange rates. The estimation results showed that increase
in bubble size also increases the probability of collapse. The collapsing probability of the
exchange rate was also shown to move faster rather than when growing or building up and
that the probability of being under the collapsing regime increases as the exchange rate is
under the state of collapse.

53
 CHAPTER VII
LIMITATIONS AND RECOMMENDATIONS

The study only investigated the evidence of bubbles in the PHP/USD exchange rate
from 1993 to 2016 due to the difficulty entailed in the acquisition of earlier data. Thus, the
author recommends the extension of the study to the real effective exchange rate and other
exchange rates relative to the Philippines Peso as wells as the extension of the time period
to be analyzed.

Moreover, this study may serve as an initial step towards the forecasting of both
financial crises reflective in the Philippine foreign exchange market and other financial
markets, as wells as the forecasting of exchange rate movements relative to the
approximation of bubble size from other exchange rate models. The study may further be
expanded through the use of other exchange rate models.

The study concluded that the early warning signal indicators, namely, Exports,
Imports, International Reserve, and Interest Rate, are reflective of the financial crises
experienced in the last two decades and can be used to estimate the probability of being
under the collapsing regime. Lastly, among the four explanatory variables, the value of the
traded goods, exports and imports were found to be the most sensitive to regime switching
from a surviving state to a collapsing state of exchange rates. Thus, for further studies,
value of exports and imports for the Philippines can be used to analyze the regime
switching property present in the exchange rate and for the forecasting of financial crises
reflective in the foreign exchange market.

54
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