Min Wei and Jonathan Wright
Abstract: Long-horizon predictive regressions in finance pose formidable econometric problems when estimated using the sample sizes that are typically available. A remedy that has been proposed by Hodrick (1992) is to run a reverse regression in which short-horizon returns are projected onto a long-run mean of some predictor. By covariance stationarity, the slope coefficient is zero in the reverse regression if and only if it is zero in the original regression, but testing the hypothesis in the reverse regression avoids small sample problems. Unfortunately this only allows us to test the null of no predictability. In this paper we show how to use the reverse regression to test other hypotheses about the slope coefficient in a long-horizon predictive regression, and to form confidence intervals for this coefficient. We show that this approach to inference works well in small samples.
Keywords: Predictive regressions, long horizons, confidence intervals, small sample problems, persistenceFull paper (177 KB PDF) | Full paper (Screen Reader Version)