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A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets

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  • Harrison Hong
  • Jeremy C. Stein

Abstract

We assume that the instantaneous riskless rate reverts towards a central tendency which in turn, is changing stochastically over time. As a result, current short-term rates are not" sufficient to predict future short-term rates movements, as would be the case if the central" tendency was constant. However, since longer-maturity bond prices incorporate information" about the central tendency, longer-maturity bond yields can be used to predict future short-term" rate movements. We develop a two-factor model of the term-structure which implies that a" linear combination of any two rates can be used as a proxy for the central tendency. Based on" this central-tendency proxy, we estimate a model of the one-month rate which performs better" than models which assume the central tendency to be constant.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6324.

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Date of creation: Dec 1997
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Handle: RePEc:nbr:nberwo:6324

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  1. Noted for July 3, 2013
    by ? in Grasping Reality with the Invisible Hand on 2013-07-03 05:36:00
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