Finance and Economics Discussion Series (FEDS)
July 2009
What is the Chance that the Equity Premium Varies Over Time? Evidence from Predictive Regressions
Jessica A. Wachter and Missaka Warusawitharana
Abstract:
We examine the evidence on stock return predictability in a Bayesian setting that includes uncertainty about both the existence and strength of predictability. We consider an investor who believes that excess stock returns exhibit predictability with prior probability q < 1. In addition, the investor downweights observed predictability by placing a prior distribution on the R2 of the predictability regression. When we apply our analysis to the dividend-price ratio, we find that even investors who are quite skeptical about the existence and strength of predictability sharply modify their views in favor of predictability when confronted by the evidence. We depart from previous model-selection work by treating the regressor as stochastic rather than known; we find that this has a large impact on inference about time-varying expected returns.
Full paper (Screen Reader Version)Keywords: Equity premium, return predictability, Bayesian methods
PDF: Full Paper
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