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Fractional cointegration and tests of present value models
Author(s) -
Caporale Guglielmo Maria,
GilAlana Luis A.
Publication year - 2003
Publication title -
review of financial economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.347
H-Index - 41
eISSN - 1873-5924
pISSN - 1058-3300
DOI - 10.1016/j.rfe.2003.09.009
Subject(s) - cointegration , mean reversion , econometrics , monte carlo method , economics , long memory , null hypothesis , stock (firearms) , mathematics , dividend , series (stratigraphy) , statistics , volatility (finance) , engineering , paleontology , biology , mechanical engineering , finance
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.