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Forecasting long- and short-horizon stock returns in a unified framework

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  • Chunsheng Zhou

Abstract

If stock prices do not follow random walks, what processes do they follow? This question is important not only for forecasting purpose, but also for theoretical analyses and derivative pricing where a tractable model of the movement of underlying stock prices is needed. Although several models have been proposed to capture the predictability of stock returns, their empirical performances have not been evaluated. This paper evaluates some popular models using a Kalman Filter technique and finds that they have serious flaws. The paper then proposes an alternative parsimonious state-space model in which state variables characterize the stochastic movements of stock returns. Using equal-weighted CRSP monthly index, the paper shows that (1) this model fits the autocorrelations of returns well over both short and longer horizons and (2) although the forecasts obtained with the state-space model are based solely on past returns, they subsume the information in other potential predictor variables such as dividend yields.

Suggested Citation

  • Chunsheng Zhou, 1996. "Forecasting long- and short-horizon stock returns in a unified framework," Finance and Economics Discussion Series 96-4, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:96-4
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    References listed on IDEAS

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    1. Campbell, John Y & Hamao, Yasushi, 1992. " Predictable Stock Returns in the United States and Japan: A Study of Long-Term Capital Market Integration," Journal of Finance, American Finance Association, vol. 47(1), pages 43-69, March.
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    8. Shmuel Kandel & Robert F. Stambaugh, "undated". "Modeling Expected Stock Returns for Long and Short Horizons," Rodney L. White Center for Financial Research Working Papers 42-88, Wharton School Rodney L. White Center for Financial Research.
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    11. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
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    13. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
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    Keywords

    Stock - Prices;

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