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Return Dynamics when Persistence is Unobservable
Author(s) -
Johnson Timothy C.
Publication year - 2001
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/1467-9965.00123
Subject(s) - unobservable , volatility (finance) , econometrics , persistence (discontinuity) , economics , rational expectations , stochastic volatility , financial economics , geotechnical engineering , engineering
This paper proposes a new theory of the sources of time‐varying second (and higher) moments in financial time series. The key idea is that fully rational agents must infer the stochastic degree of persistence of fundamental shocks. Endogenous changes in their uncertainty determine the evolution of conditional moments of returns. The model accounts for the principal observed features of volatility dynamics and implies some new ones. Most strikingly, it implies a relationship between ex post trends, or momentum, and changes in volatility.