The Log-Linear Return Approximation, Bubbles, and Predictability
AbstractWe study in detail the log-linear return approximation introduced by Campbell and Shiller (1988a). First, we derive an upper bound for the mean approximation error, given stationarity of the log dividendprice ratio. Next, we simulate various rational bubbles which have explosive conditional expectation, and we investigate the magnitude of the approximation error in those cases. We find that surprisingly the Campbell-Shiller approximation is very accurate even in the presence of large explosive bubbles. Only in very large samples do we find evidence that bubbles generate large approximation errors. Finally, we show that a bubble model in which expected returns are constant can explain the predictability of stock returns from the dividend-price ratio that many previous studies have documented.
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Bibliographic InfoArticle provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.
Volume (Year): 47 (2012)
Issue (Month): 03 (June)
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Other versions of this item:
- Tom Engsted & Thomas Q. Pedersen & Carsten Tanggaard, 2010. "The log-linear return approximation, bubbles, and predictability," CREATES Research Papers 2010-37, School of Economics and Management, University of Aarhus.
- C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models
- C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
- C65 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Miscellaneous Mathematical Tools
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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- Tom Engsted & Thomas Q. Pedersen, 2012. "Predicting returns and rent growth in the housing market using the rent-to-price ratio: Evidence from the OECD countries," CREATES Research Papers 2012-58, School of Economics and Management, University of Aarhus.
- Lof, Matthijs, 2012. "Rational Speculators, Contrarians and Excess Volatility," MPRA Paper 43490, University Library of Munich, Germany.
- Tom Engsted & Thomas Q. Pedersen, 2013. "Housing market volatility in the OECD area: Evidence from VAR based return decompositions," CREATES Research Papers 2013-04, School of Economics and Management, University of Aarhus.
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