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Fractional cointegration and tests of present value models

Author

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  • Guglielmo Maria Caporale
  • Luis A. Gil‐Alana
Abstract
This paper tests the validity of present value (PV) models of stock prices by employing a two‐step strategy for testing the null hypothesis of no cointegration against alternatives which are fractionally cointegrated. Monte Carlo simulations are conducted to evaluate the power and size properties of this test, which is shown to outperform existing ones, and to compute appropriate critical values for finite samples. It is found that stock prices and dividends are both I(1) nonstationary series, but they are fractionally cointegrated. This implies that, although there exists a long‐run relationship, which is consistent with PV models, the equilibrium errors exhibit slow mean reversion. As the error correction term possesses long memory, deviations from equilibrium are highly persistent.

Suggested Citation

  • Guglielmo Maria Caporale & Luis A. Gil‐Alana, 2004. "Fractional cointegration and tests of present value models," Review of Financial Economics, John Wiley & Sons, vol. 13(3), pages 245-258.
    • Handle: RePEc:wly:revfec:v:13:y:2004:i:3:p:245-258
    DOI: 10.1016/j.rfe.2003.09.009
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    More about this item

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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