The log-linear return approximation, bubbles, and predictability

Tom Engsted, Thomas Pedersen (tqpedersen@creates.au.dk) and Carsten Tanggaard

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We study in detail the log-linear return approximation introduced by Campbell and Shiller (1988a). First, we derive an upper bound for the mean approximation error, given stationarity of the log dividendprice ratio. Next, we simulate various rational bubbles which have explosive conditional expectation, and we investigate the magnitude of the approximation error in those cases. We find that surprisingly the Campbell-Shiller approximation is very accurate even in the presence of large explosive bubbles. Only in very large samples do we find evidence that bubbles generate large approximation errors. Finally, we show that a bubble model in which expected returns are constant can explain the predictability of stock returns from the dividend-price ratio that many previous studies have documented.

Keywords: Stock return; Taylor expansion; bubble; simulation; predictability (search for similar items in EconPapers)
JEL-codes: C32 C52 C65 G12 (search for similar items in EconPapers)
Pages: 32
Date: 2010-07-01
New Economics Papers: this item is included in nep-fmk
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Citations: View citations in EconPapers (5)

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Related works:
Journal Article: The Log-Linear Return Approximation, Bubbles, and Predictability (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2010-37

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