Business conditions and nonrandom walk behaviour of US stocks and bonds returns

Document Type

Article

Publication Title

Applied Financial Economics

ISSN

0960-3107

Volume

18

Issue

8

DOI

10.1080/09603100701222242

First Page

659

Last Page

672

Publication Date

5-1-2008

Abstract

If security returns are predictable due to rational variations in expected returns, as been argued by Fama and French (1989), then abnormal returns should follow a random walk process. This article investigates whether monthly abnormal returns on four US securities - high-grade corporate bonds, low-grade corporate bonds, large-cap stocks and small-cap stocks - exhibit a random walk pattern. Abnormal returns on these securities are derived from regressing excess security returns on three proxies of business condition (term premium (TRISK), default premium (DRISK) and dividend yield (DIVYLD)) and federal funds rate (FedFund). Four alternative test procedures - variance ratio test, nonparametric runs test, Markov chain test and time reversibility tests - are employed. This study finds that abnormal returns on all securities, with the exception of high-grade corporate bonds, exhibit nonrandom pattern between 1973 and 2002, suggesting that these four common risk factors cannot capture the time-varying returns of both stocks and bonds.

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