Parameter stability in the market model: Tests and time varying parameter estimation with UK data

This paper investigates parameter stability in the market model using a data set constructed from the companies that have remained in the London Stock Exchange FT-SE 100 index for the first decade of its existence. A battery of tests of structural stability are performed, finding that parameter instability is prevalent in the fitted market models. Two specific time varying parameter models are then investigated: a smooth transition regression and a random walk parameter model. Shifts in beta-parameters at certain non-firm-specific events, particularly the deregulatory Big Bang of October 1986, the crash a year later and the general election and later European exchange rate mechanism crisis of 1992, are found to be a feature of the data set.