Return dynamics when persistence is unobservable

Johnson, T (2000) Return dynamics when persistence is unobservable. Working Paper. London Business School IFA Working Paper.

Abstract

This paper proposes a new theory of the sources of timevarying second (and higher) moments in ficial 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.