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Journal of Financial Econometrics Advance Access published online on July 23, 2008
Journal of Financial Econometrics, doi:10.1093/jjfinec/nbn010
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© The Author 2008. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oupjournals.org

Long Memory and the Term Structure of Risk

Peter C. Schotman
     Maastricht University, NETSPAR, and CEPR

Rolf Tschernig
     University of Regensburg

Jan Budek
     KPMG

Address correspondence to Peter Schotman, Limburg Institute of Financial Economics (LIFE), Maastricht University, P.O. Box 616, 6200 MD Maastricht, Netherlands, or e-mail: P.Schotman{at}finance.unimaas.NL

JEL Classification: G11, C32


  Abstract

This paper explores the implications of asset return predictability for long-term portfolio choice when return-forecasting variables are fractionally integrated. For important predictor variables, like the dividend-price ratio, and nominal and real interest rates, we estimate orders of integration around 0.8. This leads to substantial increases of the estimated long-term risk of stocks, bonds, and cash compared to estimates obtained from a stationary VAR. Results are sensitive to the inclusion of the short-term nominal interest rate in the prediction equation of excess stock returns. Jointly with the dividend-price ratio it has significant predictive power, but contrary to the dividend-price ratio the nominal interest rate does not induce mitigating effects through mean reversion.

KEYWORDS: long-term portfolio choice, linear processes with fractional integration, term structure of risk

Received March 1, 2006; revised February 4, 2008; accepted June 23, 2008


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