Long memory and the term structure of risk

P.C. Schotman, R.J.V. Tschernig, J. Budek

Research output: Contribution to journalArticleAcademicpeer-review

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.
Original languageEnglish
Pages (from-to)459-495
Number of pages37
JournalJournal of Financial Econometrics
Volume6
Issue number4
DOIs
Publication statusPublished - 1 Jan 2008

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