Common stochastic trends in international stock prices and dividends: an example of testing overidentifying restrictions on multiple cointegration vectors

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Abstract
Based on a cointegrated VAR model, a joint test of the within-country and crosscountry low-frequency implications of the present value model of stock prices is derived and applied to postwar annual stock market data from four European countries. Following Johansen (1995) and Johansen and Juselius (1994) the test is formulated as a test of overidentifying restrictions on multiple cointegration vectors. The analysis is similar in spirit to the analysis carried out by Kasa (1992). However, whereas Kasa analyses prices and dividends in two separate VAR models and does not test restrictions implied by the present value model on the cointegration vectors, we perform the analysis within one comprehensive VAR model and test the full set of within-country and cross-country implications by a single likelihood ratio test. The empirical results indicate the presence of common trends among dividends in the four countries; how many is, however, difficult to judge. Furthermore, the results of the tests of the overidentifying restrictions are not clearcut. If dividends share one or two common trends the restrictions are not rejected at standard significance levels. However, if dividends share three common trends, the restrictions are strongly rejected.