Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets




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    • Bekaert is from the Department of Economics, Northwestern University, Evanston, IL. Hodrick is from the Department of Finance, Kellogg Graduate School of Management, Northwestern University. The authors gratefully acknowledge partial support of this research from the National Bureau of Economic Research (NBER) Committee on Dissertation Support Awards and the Kellogg Banking Research Center, respectively. We thank Laurie Bagwell, Tim Bollerslev, Robert Cumby, Robert Korajczyk, Bruno Solnik, René Stulz (the editor), Mark Watson, an anonymous referee and the participants in seminars at Carleton, Columbia, Florida, Georgetown, Illinois, McGill, Princeton, Rochester, and Yale and at the 1990 NBER Summer Institute and the 1991 Mid-West International Economics Conference for useful comments on the paper.


The paper first characterizes the predictable components in excess rates of returns on major equity and foreign exchange markets using lagged excess returns, dividend yields, and forward premiums as instruments. Vector autoregressions (VARs) demonstrate one-step-ahead predictability and facilitate calculations of implied long-horizon statistics, such as variance ratios. Estimation of latent variable models then subjects the VARs to constraints derived from dynamic asset pricing theories. Examination of volatility bounds on intertemporal marginal rates of substitution provides summary statistics that quantify the challenge facing dynamic asset pricing models.