Long Memory and the Term Structure of Risk

44 Pages Posted: 21 Feb 2008

See all articles by Rolf Tschernig

Rolf Tschernig

University of Regensburg - Department of Economics and Econometrics; Maastricht University - Department of Quantitative Economics

Jan Budek

Maastricht University

Peter C. Schotman

Maastricht University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: January 30, 2008

Abstract

This paper explores the implications of asset return predictability on long-term portfolio choice when return forecasting variables exhibit long memory. We model long memory using the class of fractionally integrated time series models. Important predictor variables for U.S. data, like the dividend-price ratio and nominal and real interest rates, are non-stationary with orders of integration around 0.8. These time series properties lead to substantial increases of the estimated long-term risk of stocks, bonds and cash compared to earlier estimates obtained from a stationary VAR. Long-term risk increases because the fluctuations in the predictor variables imply that expected returns themselves become a significant source of long-term risk. We find that results are sensitive to the specification of the prediction equation of excess stock returns. The inclusion of the short-term nominal interest rate among the predictor variables has the most profound impact. 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.

Keywords: Long-term portfolio choice, Term structure of risk, Fractional integration, Long Memory

JEL Classification: G11, C32

Suggested Citation

Tschernig, Rolf and Budek, Jan and Schotman, Peter C., Long Memory and the Term Structure of Risk (January 30, 2008). Available at SSRN: https://ssrn.com/abstract=1090192 or http://dx.doi.org/10.2139/ssrn.1090192

Rolf Tschernig

University of Regensburg - Department of Economics and Econometrics ( email )

Universitaetsstrasse 31
D-93040 Regensburg
Germany
+49 (0) 941 943 2737 (Phone)
+49 (0) 941 943 4917 (Fax)

HOME PAGE: www.wiwi.uni-regensburg.de/tschernig

Maastricht University - Department of Quantitative Economics ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

HOME PAGE: www.personeel.unimaas.nl/r.tschernig

Jan Budek

Maastricht University ( email )

P.O. Box 616
6200 MD Maastricht, 6200MD
Netherlands

Peter C. Schotman (Contact Author)

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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