Essays on the Predictability and Volatility of Asset Returns

This dissertation collects two papers regarding the econometric and economic theoryand testing of the predictability of asset returns. It is widely accepted that stockreturns are not only predictable but highly so. This belief is due to an abundanceof existing empirical literature fi nding often overwhelming evidence in favor of predictability.The common regressors used to test predictability (e.g., the dividend-priceratio for stock returns) are very persistent and their innovations are highly correlatedwith returns. Persistence when combined with a correlation between innovations inthe regressor and asset returns can cause substantial over-rejection of a true null hypothesis.This result is both well documented and well known. On the other hand,stochastic volatility is both broadly accepted as a part of return time series and largelyignored by the existing econometric literature on the predictability of returns. Thesevere e ffect that stochastic volatility can have on standard tests are demonstratedhere. These deleterious e ffects render standard tests invalid. However, this problemcan be easily corrected using a simple change of chronometer. When a return timeseries is read in the usual way, at regular intervals of time (e.g., daily observations),then the distribution of returns is highly non-normal and displays marked time heterogeneity.If the return time series is, instead, read according to a clock based onregular intervals of volatility, then returns will be independent and identically normallydistributed. This powerful result is utilized in a unique way in each chapter ofthis dissertation. This time-deformation technique is combined with the Cauchy t-test and the newly introduced martingale estimation technique. This dissertation nds noevidence of predictability in stock returns. Moreover, using martingale estimation,the cause of the Forward Premium Anomaly may be more easily discerned.