Predictive Regressions with Time-Varying Coefficients
77 Pages Posted: 17 Mar 2010 Last revised: 29 Sep 2011
Date Written: September 29, 2011
We evaluate predictive regressions that explicitly consider the time-variation of coefficients in a comprehensive Bayesian framework. For monthly returns of the S&P 500 index, we demonstrate statistical as well as economic evidence of out-of-sample predictability: relative to an investor using the historic mean, an investor using our methodology could have earned consistently positive utility gains (between 1.8 and 5.8% p.a. over different time periods). We also find that predictive models with constant coefficients are dominated by models with time-varying coefficients. Finally, we show a strong link between out-of-sample predictability and the business cycle.
Keywords: Empirical asset pricing, equity return prediction, Bayesian econometrics
JEL Classification: G12, C11
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