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Learning, Structural Instability and Present Value Calculations

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  • Hashem Pesaran
  • Davide Pettenuzzo
  • Allan Timmermann

Abstract

Present value calculations require predictions of cash flows both at near and distant future points in time. Such predictions are generally surrounded by considerable uncertainty and may critically depend on assumptions about parameter values as well as the form and stability of the data generating process underlying the cash flows. This paper presents new theoretical results for the existence of the infinite sum of discounted expected future values under uncertainty about the parameters characterizing the growth rate of the cash flow process. Furthermore, we explore the consequences for present values of relaxing the stability assumption in a way that allows for past and future breaks to the underlying cash flow process. We find that such breaks can lead to considerable changes in present values.

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File URL: http://www.usc.edu/dept/LAS/economics/IEPR/Working%20Papers/IEPR_06.42_%5BPesaran,Pettenuzo,Timmermann%5D.pdf
File Function: First version, 2006
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Bibliographic Info

Paper provided by Institute of Economic Policy Research (IEPR) in its series IEPR Working Papers with number 06.42.

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Length: 21 pages
Date of creation: Jan 2006
Date of revision:
Handle: RePEc:scp:wpaper:06-42

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Keywords: present value; stock prices; structural breaks; Bayesian learning;

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References

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  1. Garcia, Rene & Perron, Pierre, 1996. "An Analysis of the Real Interest Rate under Regime Shifts," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 111-25, February.
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  13. Gary M. Koop & Simon M. Potter, 2004. "Forecasting and estimating multiple change-point models with an unknown number of change points," Staff Reports 196, Federal Reserve Bank of New York.
  14. Chib, Siddhartha, 1998. "Estimation and comparison of multiple change-point models," Journal of Econometrics, Elsevier, vol. 86(2), pages 221-241, June.
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  16. Gary M. Koop & Simon M. Potter, 2004. "Prior elicitation in multiple change-point models," Staff Reports 197, Federal Reserve Bank of New York.
  17. Allan Timmermann, 1998. "Structural Breaks, Incomplete Information and Stock Prices," FMG Discussion Papers dp311, Financial Markets Group.
  18. Robert J. Barro, 2005. "Rare Events and the Equity Premium," NBER Working Papers 11310, National Bureau of Economic Research, Inc.
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  20. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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