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Return Predictability under Equilibrium Constraints on the Equity Premium

  • Davide Pettenuzzo

    ()

    (Department of Economics, Brandeis University)

  • Allan G. Timmermann

    (Rady School of Management, University of California, San Diego)

  • Rossen I. Valkanov

    (Rady School of Management, University of California, San Diego)

This paper proposes a new approach for incorporating theoretical constraints on return forecasting models such as non-negativity of the conditional equity premium and sign restrictions on the coefficients linking state variables to the equity premium. Our approach makes use of Bayesian methods that update the estimated parameters at each point in time in a way that optimally exploits information in these constraints. Using a variety of predictor variables from the literature on predictability of stock returns, we find that theoretical constraints have an important effect on the coefficient estimates and can significantly reduce biases and estimation errors in these. In out-of-sample forecasting experiments we find that models that exploit the theoretical restrictions produce better forecasts than unconstrained models.

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File URL: http://www.brandeis.edu/departments/economics/RePEc/brd/doc/Brandeis_WP37.pdf
File Function: First version, 2008
Download Restriction: no

Paper provided by Brandeis University, Department of Economics and International Businesss School in its series Working Papers with number 37.

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Length: 34 pages
Date of creation: Oct 2008
Date of revision:
Handle: RePEc:brd:wpaper:37
Contact details of provider: Postal:
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Web page: http://www.brandeis.edu/departments/economics/

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