Exploiting Short-Run Predictability

Abstract

This paper measures the utility gains from exploiting short-run predictability in stock returns in the presence of transaction costs, short-selling constraints and parameter uncertainty. We consider predictability in both the risk premium and the volatility of stock returns.

The utility gains from exploiting predictability in the risk premium are quite small once we take into account transaction costs or short-selling constraints. Furthermore, they quickly vanish as we consider small deviations from the estimated parameter values or from the data generating process itself. The case in favor of volatility timing is stronger. In the presence of frictions the corresponding utility gains are actually larger and they are also fairly robust to structural uncertainty.

JEL Classification: G11