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Why Are Asset Returns Predictable?

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  • Lüders, Erik
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    Abstract

    Starting from an information process governed by a geometric Brownian motion we show that asset returns are predictable if the elasticity of the pricing kernel is not constant. Declining [Increasing] elasticity of the pricing kernel leads to mean reversion and negatively autocorrelated asset returns [mean aversion and positively autocorrelated asset returns]. Under nonconstant elasticity of the pricing kernel financial ratios as the price-earnings ratio have predictive power for future asset returns. In addition, it is shown that asset prices will be governed by a time-homogeneous stochastic differential equation only under the constant elasticity pricing kernel. Hence, usually asset price processes do not satisfy the assumptions needed for empirical estimation. --

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    Bibliographic Info

    Paper provided by ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research in its series ZEW Discussion Papers with number 02-48.

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    Date of creation: 2002
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    Handle: RePEc:zbw:zewdip:670

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    Keywords: Pricing kernel; Diffusion processes; Stationarity; Predictability of asset returns; Autocorrelation;

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