Long Memory and the Term Structure of Risk

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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, ...

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.

Available versions of this item

• Long Memory and the Term Structure of Risk, working paper WP 06-009. (Deposited on 02 Aug 2006)
  • Long Memory and the Term Structure of Risk. (Deposited on 08 Dec 2008 16:49)
    • Long Memory and the Term Structure of Risk. (Deposited on 09 Dec 2008 12:23) [Currently displayed]