Two Essays in Empirical Finance: Unit-Root Testing in the Presence of Structural Breaks

Abstract: Essay 1: Real Exchange Rate Adjustment in European Transition Countries Essay 1 presents unit-root test results for real exchange rates in ten Central and Eastern European transition countries relative to the Euro during 1993:01-2005:12. Because of the shift from controlled to market economies and the accompanying crises, failed policy regimes and changes in exchange rate regimes, appropriate tests in transition countries require allowing for both structural changes and outliers. Single-equation tests reject the unit-root null for nine of ten countries. Accounting for structural breaks (and in some cases, outliers) gives much faster mean-reversion speeds than otherwise. Essay 2: Size and Power in a Battery of Unit-Root Tests Essay 2 studies the overall size of a battery of unit-root tests containing multiple alternative hypotheses and also studies the power of the tests in the battery. Under the unit-root null, the probability of no rejections in a battery of five tests, where the size of each is 5%, the size of the battery of tests is approximately 17%. Simulations for power show that generally a particular model is much more likely to reject if that model corresponds to the underlying DGP than otherwise. The paper guides the researcher in using a battery of tests. If the researcher tests the unit-root null against only a single alternative, but misspecifies the alternative, the probability of a Type II error is substantial. Use of multiple series mitigates the effect on size of using a battery of tests.