Browsing by Subject "Time-Varying Expected Returns"

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  • Kaliva, Kasimir; Koskinen, Lasse (2006)
    Insurance Supervisory Authority. Research reports 2
    This paper proposes an autoregressive regime-switching model of stock price dynamics in which the process creates pricing bubbles in one regime while error-correction prevails in the other. In the bubble regime the stock price depends negatively on inflation. In the error-correction regime it depends on the price-dividend -ratio. We find that the probability of regime-switch depends on exogenous inflation and lagged price. The model is consistent with Shleifer and Vishny’s theoretical noise trader and arbitrageur model and Modigliani’s inflation illusion phenomenon. The results emphasize the importance of inflation and the price-dividend -ratio when assessing investment risk.