Detecting multiple change points in linear models with heteroscedastic errors

Abstract: The problem of detecting change points in the regression parameters of a linear regression model with errors and covariates exhibiting heteroscedasticity is considered. Asymptotic results for weighted functionals of the cumulative sum (CUSUM) processes of model residuals are established when the model errors are weakly dependent and non-stationary, allowing for either abrupt or smooth changes in their variance. These theoretical results illuminate how to adapt standard change point test statistics for linear models to this setting. We studied such adapted change-point tests in simulation experiments, along with a finite sample adjustment to the proposed testing procedures. The results suggest that these methods perform well in practice for detecting multiple change points in the linear model parameters and controlling the Type I error rate in the presence of heteroscedasticity. We illustrate the use of these approaches in applications to test for instability in predictive regression models and explanatory asset pricing models.