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Why Are Asset Returns Predictable?

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  • Lüders, Erik

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.

Suggested Citation

  • Lüders, Erik, 2002. "Why Are Asset Returns Predictable?," ZEW Discussion Papers 02-48, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  • Handle: RePEc:zbw:zewdip:670
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    More about this item

    Keywords

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

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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