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Learning, Structural Instability, and Present Value Calculations

  • Hashem Pesaran
  • Davide Pettenuzzo
  • Allan Timmermann

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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Article provided by Taylor & Francis Journals in its journal Econometric Reviews.

Volume (Year): 26 (2007)
Issue (Month): 2-4 ()
Pages: 253-288

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Handle: RePEc:taf:emetrv:v:26:y:2007:i:2-4:p:253-288
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  1. Pesaran, M.H. & Pettenuzzo, D. & Timmermann, A., 2004. "‘Forecasting Time Series Subject to Multiple Structural Breaks’," Cambridge Working Papers in Economics 0433, Faculty of Economics, University of Cambridge.
  2. Clements, Michael P. & Hendry, David F., 1998. "Forecasting economic processes," International Journal of Forecasting, Elsevier, vol. 14(1), pages 111-131, March.
  3. Allan Timmermann & M. Hashem Pesaran, 2002. "Market Timing and Return Prediction under Model Instability," FMG Discussion Papers dp412, Financial Markets Group.
  4. David Cass & Menahem E. Yaari, 1965. "Individual Saving, Aggregate Capital Accumulation, and Efficient Growth," Cowles Foundation Discussion Papers 198, Cowles Foundation for Research in Economics, Yale University.
  5. Gary Koop & Simon M. Potter, 2009. "Prior Elicitation In Multiple Change-Point Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(3), pages 751-772, 08.
  6. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  7. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, vol. 71(3), pages 341-345, June.
  8. Allan Timmermann, 1998. "Structural Breaks, Incomplete Information and Stock Prices," FMG Discussion Papers dp311, Financial Markets Group.
  9. René Garcia & Pierre Perron, 1995. "An Analysis of the Real Interest Rate Under Regime Shifts," CIRANO Working Papers 95s-05, CIRANO.
  10. Lubos Pastor & Robert F. Stambaugh, . "The Equity Premium and Structural Breaks," Rodney L. White Center for Financial Research Working Papers 11-00, Wharton School Rodney L. White Center for Financial Research.
  11. Michael P. Clements & David F. Hendry, 2001. "Forecasting Non-Stationary Economic Time Series," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262531895, June.
  12. James H. Stock & Mark W. Watson, 1994. "Evidence on structural instability in macroeconomic times series relations," Working Paper Series, Macroeconomic Issues 94-13, Federal Reserve Bank of Chicago.
  13. Chib, Siddhartha, 1998. "Estimation and comparison of multiple change-point models," Journal of Econometrics, Elsevier, vol. 86(2), pages 221-241, June.
  14. 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.
  15. Timmermann, Allan G, 1993. "How Learning in Financial Markets Generates Excess Volatility and Predictability in Stock Prices," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 1135-45, November.
  16. Anindya Banerjee & Robin L. Lumsdaine & James H. Stock, 1990. "Recursive and Sequential Tests of the Unit Root and Trend Break Hypothesis: Theory and International Evidence," NBER Working Papers 3510, National Bureau of Economic Research, Inc.
  17. Alogoskoufis, George S & Smith, Ron, 1991. "The Phillips Curve, the Persistence of Inflation, and the Lucas Critique: Evidence from Exchange-Rate Regimes," American Economic Review, American Economic Association, vol. 81(5), pages 1254-75, December.
  18. repec:cup:cbooks:9780521634809 is not listed on IDEAS
  19. Paye, Bradley S. & Timmermann, Allan, 2006. "Instability of return prediction models," Journal of Empirical Finance, Elsevier, vol. 13(3), pages 274-315, June.
  20. Robert J. Barro, 2005. "Rare Events and the Equity Premium," NBER Working Papers 11310, National Bureau of Economic Research, Inc.
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