Non-linear predictability of UK stock market returns

Abstract

Linear predictability of stock market returns has been widely reported. However, recently developed theoretical research has suggested that due to the interaction of noise and arbitrage traders, stock returns are inherently non-linear, whereby market dynamics differ between small and large returns. This paper examines whether an exponential smooth transition threshold model, which is capable of capturing this non-linear behaviour, can provide a better characterization of UK stock market returns than either a linear model or an alternate non-linear model. The results of both in-sample and out-of-sample specification tests support the exponential smooth transition threshold model and hence the belief that investor behaviour does differ between large and small returns.