Long Memory and the Term Structure of Risk
Posted: 16 Oct 2008
There are 2 versions of this paper
Date Written: Fall 2008
Abstract
This paper explores the implications of asset return predictability for long-term portfolio choice when return-forecasting variables are fractionally integrated. For important predictor variables, like the dividend-price ratio, and nominal and real interest rates, we estimate orders of integration around 0.8. This leads to substantial increases of the estimated long-term risk of stocks, bonds, and cash compared to estimates obtained from a stationary VAR. Results are sensitive to the inclusion of the short-term nominal interest rate in the prediction equation of excess stock returns. Jointly with the dividend-price ratio it has significant predictive power, but contrary to the dividend-price ratio the nominal interest rate does not induce mitigating effects through mean reversion.
Keywords: G11, C32, long-term portfolio choice, linear processes with fractional integration, term structure of risk
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