Unit-Root Test and Excess Returns.

Several recent papers have presented evidence from foreign exchange and other markets suggesting that the log of excess returns can be characterized as first-order integrated processes (I(1)). This contrasts sharply with the "conventional" wisdom that log prices are integrated of order one I(1) and that log returns should therefore be integrated of order zoro I(0), and even more sharply with the view that past returns have no ability to predict future returns (weak market efficiency). It has been suggested that this should be interpreted as evidence of the importance of regime- switching in asset prices, since such non linear processes can produce these results even when returns are truly I(0). This paper syggests an alternative interpretation.