Publications - Thomas Quistgaard Pedersen

Testing for explosive bubbles in the presence of autocorrelated innovations

Pedersen, T. Q., Schütte, E. C. M. — Tue, 01 Sep 2020 20:57:54 +0200

We analyze an empirically important issue with recursive right-tailed unit root tests for bubbles in asset prices. First, we show that serially correlated innovations, which is a feature that is present in most financial series used to test for bubbles, can lead to severe size distortions when using either fixed or automatic (based on information criteria) lag-length selection in the auxiliary regressions underlying the test. Second, we propose a sieve-bootstrap version of these tests and show that this results in tests which control size well across a number of simulation designs both with and without highly autocorrelated innovations. We also find that these improvements in size come at a relatively low cost for the power of the tests. Finally, we apply the bootstrap tests on the housing market of OECD countries, and generally find much weaker evidence of housing bubbles compared to existing evidence.

A new index of housing sentiment

Bork, L., Møller, S. V., Pedersen, T. Q. — Wed, 01 Apr 2020 20:57:54 +0200

We propose a new measure for housing sentiment and show that it accurately tracks expectations of future house price growth rates. We construct the housing sentiment index using partial least squares on household survey responses to questions about buying conditions for houses. We find that housing sentiment explains a large share of the time variation in house prices during both boom and bust cycles, and it strongly outperforms several macroeconomic variables typically used to forecast house prices. History: Accepted by Tyler Shumway, finance. Funding: Financial support was received from the Danish Council of Independent Research [Grant DFF 4003-00022] and CREATES, Center for Research in Econometric Analysis of Time Series [Grant DNRF78], funded by the Danish National Research Foundation.

Disappearing money illusion

Engsted, T., Pedersen, T. Q. — Tue, 21 Aug 2018 20:57:54 +0200

In long-term US stock market data the price-dividend ratio strongly predicts future inflation with a positive slope coefficient up to the mid 1970s. Thereafter, the predictability turns negative. We argue that this phenomenon reflects money illusion that disappears during the 1970s. We develop a consumption-based asset pricing model with recursive preferences and either money illusion or inflation non-neutrality that can explain the predictive patterns. The model is also consistent with a structural shift around the mid 1970s in the real interest rate - inflation relationship, thus supporting the hypothesis of disappearing money illusion at that time.

Testing for Explosive Bubbles in the Presence of Autocorrelated Innovations

Pedersen, T. Q., Montes Schütte, E. C. — Thu, 16 Feb 2017 20:57:54 +0100

We analyze an empirically important issue with the recursive right-tailed unit root tests for bubbles in asset prices. First, we show that serially correlated innovations, which is a feature that is present in most financial series used to test for bubbles, can lead to severe size distortions when using either fixed or automatic (based on information criteria) lag-length selection in the auxiliary regressions underlying the test. Second, we propose a sieve-bootstrap version of these tests and show that this results in more or less perfectly sized test statistics even in the presence of highly autocorrelated innovations. We also find that these improvements in size come at a relatively low cost for the power of the tests. Finally, we apply the bootstrap tests on the housing market of OECD countries, and generally find less strong evidence of bubbles compared to existing evidence.

A New Index of Housing Sentiment

Bork, L., Møller, S. V., Pedersen, T. Q. — Mon, 14 Nov 2016 20:57:54 +0100

We propose a new measure for housing sentiment and show that it accurately tracks expectations about future house price growth rates. We construct the housing sentiment index using partial least squares on household survey responses to questions about buying conditions for houses. We …find that housing sentiment explains a large share of the time-variation in house prices during both boom and bust cycles and it strongly outperforms several macroeconomic variables typically used to forecast house prices.

The predictive power of dividend yields for future inflation: Money illusion or rational causes?

Engsted, T., Pedersen, T. Q. — Tue, 26 Apr 2016 20:57:54 +0200

In long-term US data the stock market dividend yield is a strong predictor of long-horizon inflation with a negative slope coefficient. This finding is puzzling in light of the traditional Modigliani-Cohn money illusion hypothesis according to which the dividend yield varies positively with expected inflation. To rationalize the finding we develop a consumption-based model with recursive preferences and money illusion. The model with reasonable values of risk aversion and intertemporal elasticity of substitution, and either rational or adaptive expectations, implies significantly negative slope coefficients that increase numerically with the horizon in regressions of future inflation onto the dividend yield, in accordance with the data. A purely rational version of the model with no money illusion, but with a link from expected inflation to real consumption growth, also generates a negative inflation-dividend yield relationship.

Explosive bubbles in house prices? Evidence from the OECD countries

Engsted, T., Hviid, S. J., Pedersen, T. Q. — Fri, 01 Jan 2016 20:57:54 +0100

We conduct an econometric analysis of bubbles in housing markets in the OECD area, using quarterly OECD data for 18 countries from 1970 to 2013. We pay special attention to the explosive nature of bubbles and use econometric methods that explicitly allow for explosiveness. First, we apply the univariate right-tailed unit root test procedure of Phillips et al. (2015) on the individual countries' price-rent ratio. Next, we use Engsted and Nielsen's (2012) co-explosive VAR framework to test for bubbles. We find evidence of explosiveness in many housing markets, thus supporting the bubble hypothesis. However, we also find interesting differences in the conclusions across the two test procedures. We attribute these differences to how the two test procedures control for cointegration between house prices and rent.

Predicting returns and rent growth in the housing market using the rent-price ratio: Evidence from the OECD countries

Engsted, T., Pedersen, T. Q. — Thu, 01 Jan 2015 20:57:54 +0100

Explosive bubbles in house prices? Evidence from the OECD countries

Engsted, T., Hviid, S. J., Pedersen, T. Q. — Tue, 13 Jan 2015 20:57:54 +0100

We conduct an econometric analysis of bubbles in housing markets in the OECD area, using quarterly OECD data for 18 countries from 1970 to 2013. We pay special attention to the explosive nature of bubbles and use econometric methods that explicitly allow for explosiveness. First, we apply the univariate right-tailed unit root test procedure of Phillips et al. (2012) on the individual countries price-rent ratio. Next, we use Engsted and Nielsen's (2012) co-explosive VAR framework to test for bubbles. We find evidence of explosiveness in many housing markets, thus supporting the bubble hypothesis. However, we also find interesting differences in the conclusions across the two test procedures. We attribute these differences to how the two test procedures control for cointegration between house prices and rent.

Predictable return distributions

Pedersen, T. Q. — Thu, 01 Jan 2015 20:57:54 +0100

Housing market volatility in the OECD area

Engsted, T., Pedersen, T. Q. — Wed, 01 Jan 2014 20:57:54 +0100

Vector-autoregressive models are used to decompose housing returns in 18 OECD countries into cash flow (rent) news and discount rate (return) news over the period 1970-2011. For the jajority of countries news about future returns is the main driver, and both real interest rates and risk-premia play an important role in accounting for housing market volatility. Bivariate cross-country correlations and principal components analyses indicate that part of the return movements have a common factor among the majority of countries. We explain the results in terms of global changes in credit constraints and transations costs as well as changes in monetary policy over this period. Among other things, our results shed new light on wheather excessively low interest rates by the monetary authorities was a major cause for the housing boom up to 2006.

Bias-correction in vector autoregressive models

Engsted, T., Pedersen, T. Q. — Wed, 01 Jan 2014 20:57:54 +0100

We analyze the properties of various methods for bias-correcting parameter
estimates in both stationary and non-stationary vector autoregressive models. First, we show that two analytical bias formulas from the existing literature are in fact identical. Next, based on a detailed simulation study, we show that when the model is stationary this simple bias formula compares very favorably to bootstrap bias-correction, both in terms of bias and mean squared error. In non-stationary models, the analytical bias formula performs noticeably
worse than bootstrapping. Both methods yield a notable improvement over ordinary least squares. We pay special attention to the risk of pushing an otherwise stationary model into the non-stationary region of the parameter space when correcting for bias. Finally, we consider a recently proposed reduced-bias weighted least squares estimator, and we find that
it compares very favorably in non-stationary models.

Housing market volatility in the OECD area: Evidence from VAR based return decompositions

Engsted, T., Pedersen, T. Q. — Thu, 28 Feb 2013 20:57:54 +0100

Vector-autoregressive models are used to decompose housing returns in 18 OECD countries into cash ‡ow (rent) news and discount rate (return) news. Only for two countries - Germany and Ireland - do changing expectations of future rents play a dominating role in explaining housing return volatility. For the majority of countries news about future returns is the main driver, and both real interest rates and risk premia play an important role in accounting for housing market volatility. Bivariate cross-country correlations and principal components analyses indicate that part of the return movements have a common factor among the majority of countries. However, in a minority of countries (Germany, Japan, and the Netherlands) return movements have been basically unrelated to return movements
in other countries.

Predicting returns and rent growth in the housing market using the rent-to-price ratio: Evidence from the OECD countries

Engsted, T., Pedersen, T. Q. — Mon, 17 Dec 2012 20:57:54 +0100

Abstract: We investigate the predictive power of the rent-to-price ratio for future real estate returns and rent growth in 18 OECD countries over the period 1970 to 2011. First, we document that in most countries returns are signi…cantly predictable by the rent-price ratio. An increase (decrease) in the ratio signals a future increase (decrease) in returns. Second, there are large cross-country di¤erences in how the rent-price ratio predicts rent growth. For some countries the direction of predictability is negative, for other countries it is positive. Third, the predictive patterns are highly dependent on whether returns and rents are measured in nominal or real terms. Finally, there is some evidence of sub-sample instability in the predictive patterns, especially wrt. rent growth predictability. The predictability tests are conducted within a restricted VAR framework based on the dynamic Gordon growth model. This model implies restrictions across the VAR parameters that can be used to construct powerful tests of predictability.

Return predictability and intertemporal asset allocation: Evidence from a bias-adjusted VAR model

Engsted, T., Pedersen, T. Q. — Sun, 01 Jan 2012 20:57:54 +0100

Pitfalls in VAR based return decompositions: A clarification

Engsted, T., Pedersen, T. Q., Tanggaard, C. — Sun, 01 Jan 2012 20:57:54 +0100

Bias-correction in vector autoregressive models: A simulation study

Engsted, T., Pedersen, T. Q. — Fri, 13 May 2011 20:57:54 +0200

We analyze and compare the properties of various methods for bias-correcting parameter estimates in vector autoregressions. First, we show that two analytical bias formulas from the existing literature are in fact identical. Next, based on a detailed simulation study, we show that this simple and easy-to-use analytical bias formula compares very favorably to the more standard but also more computer intensive bootstrap bias-correction method, both in terms of bias and mean squared error. Both methods yield a notable improvement over both OLS and a recently proposed WLS estimator. We also investigate the properties of an iterative scheme when applying the analytical bias formula, and we …find that this can imply slightly better fi…nite-sample properties for very small sample sizes while for larger sample sizes there is no gain by iterating. Finally, we also pay special attention to the risk of pushing an otherwise stationary model into the non-stationary region of the parameter space during the process of correcting for bias.

The Log-Linear Return Approximation, Bubbles, and Predictability

Engsted, T., Pedersen, T. Q., Tanggaard, C. — Sun, 01 Jan 2012 20:57:54 +0100

We study in detail the log-linear return approximation introduced by Campbell
and Shiller (1988a). First, we derive an upper bound for the mean approximation
error, given stationarity of the log dividend-price ratio. Next, we simulate various
rational bubbles which have explosive conditional expectation, and we investigate
the magnitude of the approximation error in those cases. We …nd that surprisingly
the Campbell-Shiller approximation is very accurate even in the presence of large
explosive bubbles. Only in very large samples do we …nd evidence that bubbles
generate large approximation errors. Finally, we show that a bubble model in which
expected returns are constant can explain the predictability of stock returns from
the dividend-price ratio that many previous studies have documented.

Return predictability and dynamic asset allocation

Pedersen, T. Q. — Fri, 01 Jan 2010 20:57:54 +0100

Strategisk og taktisk aktivallokering - forudsigelige afkasts betydning for den langsigtede investor

Larsen, A. L., Pedersen, T. Q. — Sun, 01 Jan 2006 20:57:54 +0100

Predictable return distributions

Pedersen, T. Q. — Fri, 01 Jan 2010 20:57:54 +0100

This paper provides detailed insights into predictability of the entire stock and bond return distribution through the use of quantile regression. This allows us to examine speci…c parts of the return distribution such as the tails or the center, and for a suf…ciently …ne grid of quantiles we can trace out the entire distribution. A univariate quantile regression model is used to examine stock and bond return distributions individually, while a multivariate model is used to capture their joint distribution. An empirical analysis on US data shows that certain parts of the return distributions are predictable as a function of economic state variables. The results are, however, very different for stocks and bonds. The state variables primarily predict only location shifts in the stock return distribution, while they also predict changes in higher-order moments in the bond return distribution. Out-of-sample analyses show that the relative accuracy of the state variables in predicting future returns varies across the distribution. A portfolio study shows that an investor with power utility can obtain economic gains by applying the empirical return distribution in
portfolio decisions instead of imposing an assumption of lognormally distributed
returns.

The log-linear return approximation, bubbles, and predictability

Engsted, T., Pedersen, T. Q., Tanggaard, C. — Fri, 01 Jan 2010 20:57:54 +0100

We study in detail the log-linear return approximation introduced by Campbell and Shiller (1988a). First, we derive an upper bound for the mean approximation error, given stationarity of the log dividendprice ratio. Next, we simulate various rational bubbles which have explosive conditional expectation, and we investigate the magnitude of the approximation error in those cases. We find that surprisingly the Campbell-Shiller approximation is very accurate even in the presence of large explosive bubbles. Only in very large samples do we find evidence that bubbles generate large approximation errors. Finally,we show that a bubble model in which expected returns are constant can explain the predictability of stock returns from the dividend-price ratio that many previous studies have documented.

Pitfalls in VAR based return decompositions: A clarification

Engsted, T., Pedersen, T. Q., Tanggaard, C. — Fri, 01 Jan 2010 20:57:54 +0100

Based on Chen and Zhao's (2009) criticism of VAR based return de-
compositions, we explain in detail the various limitations and pitfalls
involved in such decompositions. First, we show that Chen and Zhao's
interpretation of their excess bond return decomposition is wrong: the
residual component in their analysis is not "cashflow news" but "inter-
est rate news" which should not be zero. Consequently, in contrast
to what Chen and Zhao claim, their decomposition does not serve as
a valid caution against VAR based decompositions. Second, we point
out that in order for VAR based decompositions to be valid, the asset
price needs to be included as a state variable. In parts of Chen and
Zhao's analysis the price does not appear as a state variable, thus
rendering those parts of their analysis invalid. Finally, we clarify the
intriguing issue of the role of the residual component in equity return
decompositions. In a properly specified VAR, it makes no difference
whether return news and dividend news are both computed directly
or one of them is backed out as a residual.

The dividend-price ratio does predict dividend growth: International evidence

Engsted, T., Pedersen, T. Q. — Fri, 01 Jan 2010 20:57:54 +0100

Udgivelsesdato: September

The dividend-price ratio does predict dividend growth: International evidence

Engsted, T., Pedersen, T. Q. — Thu, 01 Jan 2009 20:57:54 +0100

Unpredictable dividend growth by the dividend-price ratio is considered a 'stylized
fact' in post war US data. Using long-term data, covering more than 80 years from
the US and three European countries, we revisit this stylized fact, and we also report
results on return predictability. We find large cross-country differences regarding
return and dividend growth predictability. For the US, we confirm Chen's (2008)
finding of a 'tale of two periods' but with the important difference that short- and
long-horizon real returns are significantly predictable in both sub-periods (1871-
1949 and 1950-2008), while long-horizon real dividend growth is unpredictable in
the early period and significantly predictable in the 'wrong' direction in the post
war period. These results are directly opposite to those reported by Chen using
nominal returns and dividend growth. For the UK, the results are more or less
similar to those for the US. For Sweden and Denmark we find no evidence of return
predictability, but strong evidence of predictable dividend growth in the 'right'
direction on both short and long horizons and over both the full sample periods
and the post war period. We also document that implied long-horizon coefficients
from VAR's often differ substantially from direct estimates in multi-year regres-
sions. Throughout, we report both standard asymptotic tests and simulated small-
sample tests and, following Cochrane (2008), we investigate the joint distribution
of dividend-price ratio coefficients in return and dividend growth regressions.

Intertemporal Asset Allocation with Habit Formation in Preferences: An Approximate Analytical Solution

Pedersen, T. Q. — Tue, 01 Jan 2008 20:57:54 +0100

In this paper we derive an approximate analytical solution to the optimal con-
sumption and portfolio choice problem of an infinitely-lived investor with power
utility defined over the difference between consumption and an external habit. The
investor is assumed to have access to two tradable assets: a risk free asset with
constant return and a risky asset with a time-varying premium. We extend the ap-
proach proposed by Campbell and Viceira (1999), which builds on log-linearizations
of the Euler equation, intertemporal budget constraint, and portfolio return, to also
contain the log-linearized surplus consumption ratio. The "difference habit model"
implies that the relative risk aversion is time-varying which is in line with recent ev-
idence from the asset pricing literature. We show that accounting for habit a¤ects
both the myopic and intertemporal hedge component of optimal asset demand, and
introduces an additional component that works as a hedge against changes in the
investor's habit level. In an empirical application, we calibrate the model to U.S.
data and show that habit formation has significant effects on both the optimal
consumption and portfolio choice compared to a standard CRRA utility function.

Return predictability and intertemporal asset allocation: Evidence from a bias-adjusted VAR model

Engsted, T., Pedersen, T. Q. — Tue, 01 Jan 2008 20:57:54 +0100

We extend the VAR based intertemporal asset allocation approach from Campbell
et al. (2003) to the case where the VAR parameter estimates are adjusted for small-
sample bias. We apply the analytical bias formula from Pope (1990) using both
Campbell et al.'s dataset, and an extended dataset with quarterly data from 1952
to 2006. The results show that correcting the VAR parameters for small-sample
bias has both quantitatively and qualitatively important e¤ects on the strategic
intertemporal part of optimal portfolio choice, especially for bonds: for intermediate
values of risk-aversion, the intertemporal hedging demand for bonds - and thereby
the total demand for bonds - is strongly reduced by the bias-adjustment. We also
investigate the robustness of the results by changing the lag-length and one of the
state variables of the VAR.