Unbalanced Regressions and the Predictive Equation
Daniela Osterrieder (),
Daniel Ventosa-Santaulària () and
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Daniela Osterrieder: Rutgers Business School and CREATES, Postal: Department of Finance and Economics, 1 Washington Park, Newark NJ 07102
CREATES Research Papers from Department of Economics and Business Economics, Aarhus University
Predictive return regressions with persistent regressors are typically plagued by (asymptotically) biased/inconsistent estimates of the slope, non-standard or potentially even spurious statistical inference, and regression unbalancedness. We alleviate the problem of unbalancedness in the theoretical predictive equation by suggesting a data generating process, where returns are generated as linear functions of a lagged latent I(0) risk process. The observed predictor is a function of this latent I(0) process, but it is corrupted by a fractionally integrated noise. Such a process may arise due to aggregation or unexpected level shifts. In this setup, the practitioner estimates a misspecified, unbalanced, and endogenous predictive regression. We show that the OLS estimate of this regression is inconsistent, but standard inference is possible. To obtain a consistent slope estimate, we then suggest an instrumental variable approach and discuss issues of validity and relevance. Applying the procedure to the prediction of daily returns on the S&P 500, our empirical analysis confirms return predictability and a positive risk-return trade-off.
Keywords: Title:; Time-varying; disaster; risk; models:; An; empirical; assessment; of; the; Rietz-Barro; hypothesis (search for similar items in EconPapers)
JEL-codes: G17 C22 C26 C58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2015-09
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