Predicting Returns with a Co-Fractional VAR Model

49 Pages Posted: 22 Jan 2011

See all articles by Daniela Osterrieder

Daniela Osterrieder

Rutgers Business School; CREATES

Peter C. Schotman

Maastricht University - Department of Finance

Date Written: January 13, 2011

Abstract

We use co-fractional models to evaluate the predictive relations between returns and a valuation ratio. The co-fractional model can handle situations where financial returns are predicted using persistent valuation ratios, like dividend to price. For our application we consider very long time series, covering 355 years of real-estate returns and rent to price ratios. We find robust evidence of a fractional root of d=0.75 in the rent to price ratio. The co-fractional model empirically outperforms the traditional triangular time-series model of return predictability. For annual data, the difference in predictive R-squared is about 8%. We conclude that the co-fractional VAR provides an alternative parsimonious model for the interaction between returns and valuation ratios. The long-memory properties of the fractional model have important implications for the fi t of present-value models and the term structure of risk.

Suggested Citation

Osterrieder, Daniela and Schotman, Peter C., Predicting Returns with a Co-Fractional VAR Model (January 13, 2011). Available at SSRN: https://ssrn.com/abstract=1745020 or http://dx.doi.org/10.2139/ssrn.1745020

Daniela Osterrieder (Contact Author)

Rutgers Business School ( email )

Janice H. Levin Bldg., Room 121
94 Rockafeller Road
Piscataway, NJ 08854-8054
United States

CREATES ( email )

Aarhus University
Fuglesangs Alle 4
DK-8210 Aarhus C
Denmark

Peter C. Schotman

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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