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Mean Reversion in Net Discount Ratios: A Study in the Context of Fractionally Integrated Models
Author(s) -
Clark Steven P.,
Coggin T. Daniel,
Neale Faith R.
Publication year - 2008
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/j.1539-6975.2007.00256.x
Subject(s) - mean reversion , economics , context (archaeology) , econometrics , earnings , present value , damages , value (mathematics) , stochastic discount factor , statistics , mathematics , capital asset pricing model , finance , paleontology , political science , law , biology
This article introduces a new alternative to the ongoing debate about stationarity and mean reversion of the net discount ratio. Modeling the net discount ratio as a fractionally integrated ( I ( d )) process, we apply recently developed frequency domain estimation procedures and find evidence that the net discount ratio is an I ( d ) process with 1/2 ≤ d < 1. Although nonstationary, such series behave like stationary processes in one interesting respect; they are mean‐reverting. We present results from a simulation experiment suggesting that the finding of a nonstationary, but mean‐reverting net discount ratio generally supports the validity of current practice in estimating economic damages in personal injury litigation. Moreover, if recognized and accounted for, the presence of long memory in the net discount ratio even offers the potential to significantly improve forecasts of the present value of future earnings.