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Cointegration and Tests of Present Value Models

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Abstract

In a model where a variable Y is proportional to the present value, with constant discount rate, of expected future values of a variable y, the "spread" S - Y - qy will be stationary for some q whether or not y must be differenced to induce stationarity. Thus, Y and y are cointegrated. The model implies that S is proportional to the optimal forecast of S*, the present value of future changes in y. We use vector autoregressive methods, and recent literature on cointegrated processes, to test the model. When Y is the long-term interest rate and y the short-term interest rate, we find in postwar United States data that S behaves much like an optimal forecast of S* even though as earlier research has shown it is negatively correlated with next period's change in Y. When Y is a real stock price index and y the corresponding real dividend, using annual United States data for 1871-1986 we obtain less encouraging results for the model, although the results are sensitive to the assumed discount rate.

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File URL: http://cowles.econ.yale.edu/P/cd/d07b/d0785.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 785.

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Length: 41 pages
Date of creation: Mar 1986
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Publication status: Published in Journal of Political Economy (October 1987), 95: 1062-1088; also in Robert F. Engle and Clive W.J. Granger (eds.), Long-Run Economic Relationships: Readings in Cointegration, Oxford University Press, 1991, pp. 191-217; and Andrew W. Lo (ed.), Financial Econometrics, Edward Elgar, 2005
Handle: RePEc:cwl:cwldpp:785

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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Keywords: Cointegration; present value methods; stock price index; interest rates; term structure; volatility; efficient markets;

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  2. Modigliani, Franco & Shiller, Robert J, 1973. "Inflation, Rational Expectations and the Term Structure of Interest Rates," Economica, London School of Economics and Political Science, vol. 40(157), pages 12-43, February.
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  5. Shiller, Robert J., 1981. "Alternative tests of rational expectations models : The case of the term structure," Journal of Econometrics, Elsevier, vol. 16(1), pages 71-87, May.
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  8. Hamilton, James D. & Whiteman, Charles H., 1985. "The observable implications of self-fulfilling expectations," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 353-373, November.
  9. Dickey, David A & Fuller, Wayne A, 1981. "Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root," Econometrica, Econometric Society, vol. 49(4), pages 1057-72, June.
  10. Marsh, Terry A & Merton, Robert C, 1986. "Dividend Variability and Variance Bounds Tests for the Rationality ofStock Market Prices," American Economic Review, American Economic Association, vol. 76(3), pages 483-98, June.
  11. Gregory Mankiw, N. & Shapiro, Matthew D., 1985. "Trends, random walks, and tests of the permanent income hypothesis," Journal of Monetary Economics, Elsevier, vol. 16(2), pages 165-174, September.
  12. Robert J. Shiller, 1985. "Conventional Valuation and the Term Structure of Interest Rates," NBER Working Papers 1610, National Bureau of Economic Research, Inc.
  13. Campbell, John Y, 1987. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," Econometrica, Econometric Society, vol. 55(6), pages 1249-73, November.
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  16. Baillie, Richard T & Lippens, Robert E & McMahon, Patrick C, 1983. "Testing Rational Expectations and Efficiency in the Foreign Exchange Market," Econometrica, Econometric Society, vol. 51(3), pages 553-63, May.
  17. Takatoshi Ito, 1984. "Use of (Time-Domain) Vector Autoregressions to Test Uncovered Interest Parity," NBER Working Papers 1493, National Bureau of Economic Research, Inc.
  18. Lars Peter Hansen & Thomas J. Sargent, 1981. "Exact linear rational expectations models: specification and estimation," Staff Report 71, Federal Reserve Bank of Minneapolis.
  19. Sargent, Thomas J., 1979. "A note on maximum likelihood estimation of the rational expectations model of the term structure," Journal of Monetary Economics, Elsevier, vol. 5(1), pages 133-143, January.
  20. Scott, Louis O, 1985. "The Present Value Model of Stock Prices: Regression Tests and Monte Carlo Results," The Review of Economics and Statistics, MIT Press, vol. 67(4), pages 599-605, November.
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  22. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
  23. Sawa, Takamitsu, 1978. "Information Criteria for Discriminating among Alternative Regression Models," Econometrica, Econometric Society, vol. 46(6), pages 1273-91, November.
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