Return Dynamics when Persistence is Unobservable

Timothy C. Johnson

Mathematical Finance, 2001, vol. 11, issue 4, 415-445

Abstract: This paper proposes a new theory of the sources of time‐varying second (and higher) moments in financial time series. The key idea is that fully rational agents must infer the stochastic degree of persistence of fundamental shocks. Endogenous changes in their uncertainty determine the evolution of conditional moments of returns. The model accounts for the principal observed features of volatility dynamics and implies some new ones. Most strikingly, it implies a relationship between ex post trends, or momentum, and changes in volatility.

Date: 2001
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