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Sep 06, 2018

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Efficient Market Theory

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Efficient Market Theory

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Excess Volatility? (Given constant expected return)

𝑑𝑑𝑡𝑡+1 +𝑃𝑃𝑡𝑡+1 𝑑𝑑

, 𝐸𝐸 (𝑟𝑟̃𝑡𝑡+1 ) = 𝑟𝑟 (𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐), 𝑃𝑃𝑡𝑡 = 𝐸𝐸(∑∞

𝑡𝑡+𝑗𝑗

1 + 𝑟𝑟̃𝑡𝑡+1 = 𝑗𝑗=1 (1+𝑟𝑟)𝑗𝑗 )

𝑃𝑃𝑡𝑡

a proxy for fundamentals!).

- RWH(random walk hypothesis) → 𝐸𝐸𝑡𝑡 (𝑃𝑃𝑡𝑡+1 ) = 𝑃𝑃𝑡𝑡

- Why? ① Return is time varying, ② Investors does not have rational expectation.

- EMH (The Efficient Markets Hypothesis) turns out to be wrong, because stock market is not

informational efficient.

✓ Summers (1981)

𝑑𝑑𝑡𝑡+𝑗𝑗

- Price = PV of future dividends: 𝑃𝑃𝑡𝑡 = 𝐸𝐸(∑∞

𝑗𝑗=1 (1+𝑟𝑟)𝑗𝑗 )

- Investor sentiment by irrational investors (noise traders) cause excess fluctuations in the stock

market?

1−1

Vol( Pt ) �� Vol( dt ) does not hold (movement of dt is much smoother), because of

investor’s sentiment. If then, rational expectation is wrong!

✓ Campbell(1991)

Dt

- Dividend measurement issue? : dividend yield → But dividend(Dt ) is not a good proxy!

𝑃𝑃𝑡𝑡−1

② firm level are different!

2018, Kyungsun Kim

Return Predictability?

- Winner Loser Reversal: Long loser portfolio and short winner portfolio → RL − 𝑅𝑅 𝑊𝑊

arbitrage(즉각적으로 arbitrage가 일어나지 않음)

- Mean reversion: Correction of mispricing moves quicker than overreaction.

extrapolative expectation.

Price multiples

Rt = 𝛼𝛼 + 𝛽𝛽(𝑃𝑃/𝐸𝐸)𝑡𝑡−1 + εt

Interpretation

(1) Weak form of market efficiency is violated.

(2) Price contains information independent of fundamental (sentiment).

- Two different approaches: ① Risk? (Time varying risk premium): Efficient market does not

imply random walk nor no return predictability. ② Mispricing (Time varying investor

sentiment) that persists (Limit of arbitrage); Early to late 90s.

2018, Kyungsun Kim

But E[Rt+1 ] is time varying: Et [𝑅𝑅𝑡𝑡+1 ] = 𝛼𝛼 + 𝛽𝛽 ∙ 𝑋𝑋𝑡𝑡−1

𝑑𝑑�𝑡𝑡+1 +𝑃𝑃�𝑡𝑡+1

1 + 𝑟𝑟̃𝑡𝑡+1 = 𝑃𝑃𝑡𝑡

When risk aversion increases in the boom period, ① willingness to pay increases (Pt ↑) →

Pt ↑

② people require less risk premium → Rt+1 ↓ (adjustment가 일어남)

𝐸𝐸𝑡𝑡

Pt ↑

⇒ and Rt+1 ↓ are negatively correlated.

𝐸𝐸𝑡𝑡

① specification problem in P/E regression ② Even when model is correctly specified,

standard errors can still be biased (both in time series and panel set ups): When s.e. has

�

β

downward bias, t = 𝑠𝑠.𝑒𝑒. is also biased upward.

2018, Kyungsun Kim

[L2]

EMH implies that P/E and D/P should be useful in forecasting future dividend growth, future

earnings growth, or future productivity growth. But the ratios do poorly in forecasting any of

them, rather appears to be useful in forecasting future stock price changes, contrary to the

simple EMH.

If risk premium is time-varying, D/P is high when prices are depressed because of high risk

premium (future expected return). If not, D/P is high when stocks are underpriced and

subsequent price correction will be positive. Return predictability undermines the validity of

constant expected return and RWH, not EMH.

Pt+1 + 𝐷𝐷𝑡𝑡+1

1 + 𝑅𝑅𝑡𝑡+1 =

𝑃𝑃𝑡𝑡

𝐷𝐷 𝐷𝐷

= log[Pt+1 ∙ (1 + 𝑃𝑃𝑡𝑡+1 )] − log(Pt ) = log(Pt+1 ) + 𝑙𝑙𝑙𝑙𝑙𝑙(1 + 𝑃𝑃𝑡𝑡+1 ) − log(𝑃𝑃𝑡𝑡 )

𝑡𝑡+1 𝑡𝑡+1

= 𝑝𝑝𝑡𝑡+1 − 𝑝𝑝𝑡𝑡 + log�1 + 𝑒𝑒𝑒𝑒𝑒𝑒(𝑑𝑑𝑡𝑡+1 − 𝑝𝑝𝑡𝑡+1 )�

1 �������

exp�𝑑𝑑 − 𝑝𝑝�

= 𝑝𝑝𝑡𝑡+1 + dt+1 − 𝑝𝑝𝑡𝑡 + 𝑘𝑘

1 + exp(𝑑𝑑 �������

− 𝑝𝑝) 1 + exp�𝑑𝑑�������

− 𝑝𝑝�

∵ log�1 + 𝑒𝑒𝑒𝑒𝑒𝑒(𝑑𝑑𝑡𝑡+1 − 𝑝𝑝𝑡𝑡+1 )�

�������

exp�𝑑𝑑 − 𝑝𝑝�

≈ log(1 + exp�𝑑𝑑 �������

− 𝑝𝑝� + �������

∙ (𝑑𝑑𝑡𝑡+1 − 𝑝𝑝𝑡𝑡+1 − �𝑑𝑑 − 𝑝𝑝�)

1 + exp�𝑑𝑑�������

− 𝑝𝑝�

Here, Taylor expansion is applied to f(x) = log(1 + 𝑒𝑒𝑒𝑒𝑒𝑒(𝑥𝑥 )), and we have first derivative

exp(𝑥𝑥)

f ′ (x) = 1+exp(x).

1 1

where ρ = ������) and k = −logρ − (1 − ρ) ∙ log( − 1).

1+exp(𝑑𝑑−𝑝𝑝 𝜌𝜌

Imposing terminal condition lim 𝜌𝜌 𝑗𝑗 𝑝𝑝𝑡𝑡+𝑗𝑗 = 0, we get

𝑗𝑗→∞

∞

𝑘𝑘

𝑝𝑝𝑡𝑡 ≈ 𝑘𝑘 + 𝜌𝜌𝑝𝑝𝑡𝑡+1 + (1 − 𝜌𝜌)𝑑𝑑𝑡𝑡+1 − 𝑟𝑟𝑡𝑡+1 = + � 𝜌𝜌 𝑗𝑗 �(1 − 𝜌𝜌)𝑑𝑑𝑡𝑡+1+𝑗𝑗 − 𝑟𝑟𝑡𝑡+1+𝑗𝑗 �

1 − 𝜌𝜌

𝑗𝑗=0

∞ ∞

𝑘𝑘

= + 𝐸𝐸𝑡𝑡 � 𝜌𝜌 𝑗𝑗 �(1 − 𝜌𝜌)𝑑𝑑𝑡𝑡+1+𝑗𝑗 � − 𝐸𝐸𝑡𝑡 � 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑡𝑡+1+𝑗𝑗 �

1 − 𝜌𝜌

𝑗𝑗=0 𝑗𝑗=0

𝑘𝑘

= + 𝑝𝑝𝐶𝐶𝐶𝐶,𝑡𝑡 − 𝑝𝑝𝐷𝐷𝐷𝐷,𝑡𝑡

1 − 𝜌𝜌

2018, Kyungsun Kim

where 𝑝𝑝𝐶𝐶𝐶𝐶,𝑡𝑡 is the component of price due to expected future cash flow, and 𝑝𝑝𝐷𝐷𝐷𝐷,𝑡𝑡 is the

component of price due to expected future discount rate.

If log dividend follows a unit root process, we can subtract dt from both sides.

Let δt+1 ≡ 𝑑𝑑𝑡𝑡+1 − 𝑝𝑝𝑡𝑡+1 . Then pt+1 − 𝑝𝑝𝑡𝑡 = δt − 𝛿𝛿𝑡𝑡+1 + ∆𝑑𝑑𝑡𝑡+1 . From (1), we have:

= 𝑘𝑘 + 𝜌𝜌𝑝𝑝𝑡𝑡+1 + (1 − 𝜌𝜌)(𝛿𝛿𝑡𝑡+1 + 𝑝𝑝𝑡𝑡+1 ) − 𝑝𝑝𝑡𝑡

= 𝑘𝑘 + 𝑝𝑝𝑡𝑡+1 + (1 − 𝜌𝜌)𝛿𝛿𝑡𝑡+1 − 𝑝𝑝𝑡𝑡

= 𝑘𝑘 + (1 − 𝜌𝜌)𝛿𝛿𝑡𝑡+1 + 𝛿𝛿𝑡𝑡 − 𝛿𝛿𝑡𝑡+1 + ∆𝑑𝑑𝑡𝑡+1

= 𝑘𝑘 + 𝛿𝛿𝑡𝑡 − 𝜌𝜌𝛿𝛿𝑡𝑡+1 + ∆𝑑𝑑𝑡𝑡+1

∞

𝑘𝑘

= ⋯ = � 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑡𝑡+1+𝑗𝑗 − ∆𝑑𝑑𝑡𝑡+1+𝑗𝑗 � −

1 − 𝜌𝜌

𝑗𝑗=0

∞

−𝑘𝑘

∴ 𝑑𝑑𝑡𝑡 − 𝑝𝑝𝑡𝑡 = + 𝐸𝐸𝑡𝑡 � 𝜌𝜌 𝑗𝑗 �−∆𝑑𝑑𝑡𝑡+1+𝑗𝑗 + 𝑟𝑟𝑡𝑡+1+𝑗𝑗 �

1 − 𝜌𝜌

𝑗𝑗=0

⇒ Model predicts that D/P can be high either due to risk or behavioral reason(overreaction);

(1) ∆𝑑𝑑𝑡𝑡+1+𝑗𝑗 is negative or 𝑟𝑟𝑡𝑡+1+𝑗𝑗 is very high and (2) predictive power is stronger at long

horizon.

We consider the regressions of the form Et 𝑟𝑟𝑡𝑡+1 = 𝑟𝑟 + 𝑥𝑥𝑡𝑡 .

That is, 𝑟𝑟𝑡𝑡+1 = 𝑟𝑟 + 𝑥𝑥𝑡𝑡 + 𝑢𝑢𝑡𝑡+1 , where 𝑥𝑥𝑡𝑡 is a dividend yield, book-to-price ratio, or a function

of interest rates, and 𝑢𝑢𝑡𝑡+1 is the regression’s disturbance.

Assume that xt , the dividend yield(D/P), is an AR(1): 𝑥𝑥𝑡𝑡+1 = 𝜙𝜙𝑥𝑥𝑡𝑡 + 𝜁𝜁𝑡𝑡+1 .

If 𝜁𝜁𝑡𝑡+1 and 𝑢𝑢𝑡𝑡+1 are negatively correlated, then the bias in 𝜙𝜙 affects the bias in 𝑟𝑟𝑡𝑡+1 .

2018, Kyungsun Kim

✓ Stambaugh (1999)

When a rate of return is regressed on a lagged stochastic regressor, such as a dividend

yield, the regression disturbance is correlated with the regressor's innovation.

�

Finite-sample properties of 𝜷𝜷

where ρ2 < 1 and (ut 𝑣𝑣𝑡𝑡 )′ is distributed N(0, Σ), identically and independently across t,

𝑢𝑢𝑡𝑡 𝜎𝜎 2 𝜎𝜎𝑢𝑢𝑢𝑢

where cov ��𝑣𝑣 � , [𝑢𝑢𝑡𝑡 𝑣𝑣𝑡𝑡 ]� = Σ = [ 𝑢𝑢 ].

𝑡𝑡 𝜎𝜎𝑢𝑢𝑢𝑢 𝜎𝜎𝑣𝑣2

The results show that 𝛽𝛽̂ is biased upward. The bias in 𝛽𝛽̂ is related to the bias in 𝜌𝜌�, the

sample first-order autocorrelation of 𝑥𝑥𝑡𝑡 .

𝜃𝜃�

Define � � = (X′ X)−1 𝑋𝑋′𝑥𝑥, where X = [𝐼𝐼𝑇𝑇 𝑥𝑥 ], 𝑥𝑥 = (𝑥𝑥1 , … , 𝑥𝑥𝑇𝑇 )′.

𝜌𝜌�

𝜎𝜎

E�𝛽𝛽̂ − 𝛽𝛽� = 𝜎𝜎𝑢𝑢𝑢𝑢

2 E(𝜌𝜌

� − 𝜌𝜌) (2)

𝑣𝑣

The bias in 𝜌𝜌� is negative, and since price appears in the denominator of dividend yield, the

unexpected return, 𝑢𝑢𝑡𝑡 , and is negatively correlated with the innovation in dividend yield, 𝑣𝑣𝑡𝑡 .

2018, Kyungsun Kim

Thus, from equation (2), the magnitude of the positive bias in 𝛽𝛽̂ is many times that of the

negative bias in 𝜌𝜌�.

1

Under the normality assumption, a well-known approximation for the bias in 𝜌𝜌�, to order ,

𝑇𝑇

1+3𝜌𝜌

is given by − 𝑇𝑇

, as shown by Marriott and Pope (1954) and Kendall (1954). Thus, equation

(2) yields a similar approximation for the bias in 𝛽𝛽̂:

𝜎𝜎 1+3𝜌𝜌 1

E�𝛽𝛽̂ − 𝛽𝛽� = − 𝜎𝜎𝑢𝑢𝑢𝑢

2 � � + 𝑂𝑂( 2 ) (3)

𝑣𝑣 𝑇𝑇 𝑇𝑇

To sum up, In the case where the dividend-price ratio is the predictor, we expect negative 𝛾𝛾

so downward bias in 𝜙𝜙� produces upward bias in 𝛽𝛽̂:

1 + 3𝜙𝜙 1

𝐸𝐸�𝜙𝜙� − 𝜙𝜙� = − � � + 𝑜𝑜 � 2 �

𝑇𝑇 𝑇𝑇

𝜌𝜌(1 + 3𝜙𝜙)

𝐸𝐸�𝛽𝛽̂ − 𝛽𝛽� =

(1 − 𝜌𝜌𝜌𝜌)𝑇𝑇

Note that, when persistent regressor has innovations orthogonal to asset returns (ex. Inflation),

no need to worry about such bias.

✓ Lewellen (2004)

Predictive regressions are subject to small-sample biases, but the correction used by prior

studies can substantially understate forecasting power by implicitly discarding the information

we have about 𝜌𝜌� − 𝜌𝜌.

𝑥𝑥𝑡𝑡 = 𝜙𝜙 + 𝜌𝜌𝑥𝑥𝑡𝑡−1 + 𝜇𝜇𝑡𝑡

where ρ < 1, and εt and µt are negatively correlated. Since an increase in price leads to a

decrease in DY, the residuals εt and µt are negatively correlated. It follows that 𝜀𝜀𝑡𝑡 is

correlated with 𝑥𝑥𝑡𝑡 in the predictive regression, violating one of the assumptions of OLS

(which requires independence at all leads and lags).

Denote the matrix of regressors as X, the coefficient vectors as 𝑏𝑏 = (𝛼𝛼 𝛽𝛽)′ and 𝑝𝑝 =

(𝜙𝜙 𝜌𝜌)′, and the residual vectors as 𝜀𝜀 and 𝜇𝜇.

2018, Kyungsun Kim

In the usual OLS setting, the estimation errors are expected to be zero. That is not true

here: autocorrelations are biased downward in finite samples, and this bias feeds into the

predictive regression through the correlation between 𝜀𝜀𝑡𝑡 and 𝜇𝜇𝑡𝑡 . Specifically, we can write

εt = 𝛾𝛾𝜇𝜇𝑡𝑡 + 𝑣𝑣𝑡𝑡 , where γ = cov(𝜀𝜀, 𝜇𝜇)/𝑣𝑣𝑣𝑣𝑣𝑣(𝜇𝜇). Thus, we obtain:

where η ≡ (𝑋𝑋 ′ 𝑋𝑋)−1 𝑋𝑋 ′ 𝑣𝑣. The variable 𝑣𝑣𝑡𝑡 is independent of 𝜇𝜇𝑡𝑡 , and consequently 𝑥𝑥𝑡𝑡 , at all

leads and lags. It follows that η has mean zero and variance σ2𝑣𝑣 (𝑋𝑋 ′ 𝑋𝑋)−1 . Taking

expectations yields:

Sample autocorrelations are biased downward by roughly −(1 + 3𝜌𝜌)/𝑇𝑇, inducing an upward

bias in the predictive slope (γ < 0). Although 𝛽𝛽̂ and 𝜌𝜌� are not bivariate normal due to the

irregularities in sample autocorrelations, 𝛽𝛽̂ is normally distributed conditional on 𝜌𝜌�.

which is the realized bias in 𝛽𝛽̂. This implies that, if we knew 𝜌𝜌� − 𝜌𝜌, an unbiased estimator of

𝛽𝛽 could be obtained by subtracting 𝛾𝛾(𝜌𝜌� − 𝜌𝜌) from 𝛽𝛽.

Even though we don’t know 𝜌𝜌� − 𝜌𝜌, we can put a lower bound on it by assuming that 𝜌𝜌 ≈

1. This assumption, in turn, gives an upper bound on the ‘bias’ in 𝛽𝛽̂.

Given the true 𝜌𝜌, this estimator is normally distributed with mean 𝛽𝛽 and variance

𝜎𝜎𝑣𝑣2 (𝑋𝑋 ′ 𝑋𝑋)−1

(2,2) . The autocorrelation is unknown, but as long as DY is stationary, the most

⇒ From an ex ante perspective, the conditional test has greater power when 𝜌𝜌 is close to

one, but the opposite is true once 𝜌𝜌 drops below some level that depends on the other

parameters.

The regression model is:

If |𝜌𝜌| < 1 and fixed, 𝑥𝑥𝑡𝑡 is integrated of order zero, denoted as I(0). If |𝜌𝜌| = 1, 𝑥𝑥𝑡𝑡 is

integrated of order one, denoted as I(1). Assume that the innovations are independently and

2018, Kyungsun Kim

identically distributed (i.i.d.) normal with a known covariance matrix, that is, 𝑤𝑤𝑡𝑡 =

(𝑢𝑢𝑡𝑡 𝑒𝑒𝑡𝑡 )′ ~ 𝑁𝑁(𝟎𝟎, 𝚺𝚺), where

𝜎𝜎𝑢𝑢2 𝜎𝜎𝑢𝑢𝑢𝑢

Σ=� �.

𝜎𝜎𝑢𝑢𝑢𝑢 𝜎𝜎𝑒𝑒2

We also assume that the correlation between the innovations, δ = σue /(𝜎𝜎𝑢𝑢 𝜎𝜎𝑒𝑒 ), is negative.

The joint log likelihood for the regression model is given by

𝑇𝑇

1 (𝑟𝑟𝑡𝑡 − 𝛼𝛼 − 𝛽𝛽𝑥𝑥𝑡𝑡−1 )2 (𝑟𝑟𝑡𝑡 − 𝛼𝛼 − 𝛽𝛽𝑥𝑥𝑡𝑡−1 )(𝑥𝑥𝑡𝑡 − 𝛾𝛾 − 𝜌𝜌𝑥𝑥𝑡𝑡−1 )

𝐿𝐿(𝛽𝛽, 𝜌𝜌, 𝛼𝛼, 𝛾𝛾 ) = − � � − 2𝛿𝛿

1 − 𝛿𝛿 2 2

𝜎𝜎𝑢𝑢 𝜎𝜎𝑢𝑢 𝜎𝜎𝑒𝑒

𝑡𝑡=1

(𝑥𝑥𝑡𝑡 − 𝛾𝛾 − 𝜌𝜌𝑥𝑥𝑡𝑡−1 )2

+ �,

𝜎𝜎𝑒𝑒2

up to a multiplicative constant of 1/2 and an additive constant. Note that bivariate normal

distribution is:

𝑓𝑓 (𝑥𝑥1 , 𝑥𝑥2 ) = exp �− � −

2𝜋𝜋𝜎𝜎1 𝜎𝜎2 �1 − 𝜌𝜌 2 2(1 − 𝜌𝜌 2 ) 𝜎𝜎12 𝜎𝜎1 𝜎𝜎2

(𝑥𝑥2 − 𝜇𝜇2 )2

+ �� ,

𝜎𝜎22

𝜎𝜎

where 𝜌𝜌 ≡ cor(x1 , 𝑥𝑥2 ) = 𝜎𝜎 12 .

𝜎𝜎 1 2

t-test

The focus of this paper is the null hypothesis 𝛽𝛽 = 𝛽𝛽0 . One way to test the hypothesis in the

presence of the nuisance parameter 𝜌𝜌 is through the maximum likelihood ratio test (LRT).

𝑇𝑇

Let 𝑥𝑥̅𝑡𝑡−1 = 𝑥𝑥𝑡𝑡−1 − 𝑇𝑇 −1 Σ𝑡𝑡=1 𝑥𝑥𝑡𝑡−1 be the de-meaned predictor variable. Let 𝛽𝛽̂ be the OLS

estimator of 𝛽𝛽, and let

𝛽𝛽̂ − 𝛽𝛽0

𝑡𝑡(𝛽𝛽0 ) = 𝑇𝑇 2 )−1/2

𝜎𝜎𝑢𝑢 (Σ𝑡𝑡=1 𝑥𝑥̅𝑡𝑡−1

𝑚𝑚𝑚𝑚𝑚𝑚 𝐿𝐿(𝛽𝛽, 𝜌𝜌, 𝛼𝛼, 𝛾𝛾 ) − 𝑚𝑚𝑚𝑚𝑚𝑚 𝐿𝐿(𝛽𝛽0 , 𝜌𝜌, 𝛼𝛼, 𝛾𝛾 ) = 𝑡𝑡(𝛽𝛽0 )2 > C,

𝛽𝛽,𝜌𝜌,𝛼𝛼,𝛾𝛾 𝜌𝜌,𝛼𝛼,𝛾𝛾

for some constant C. Note that we would obtain the same test above starting from the

𝑇𝑇 (

marginal likelihood 𝐿𝐿(𝛽𝛽, 𝛼𝛼 ) = −Σ𝑡𝑡=1 𝑟𝑟𝑡𝑡 − 𝛼𝛼 − 𝛽𝛽𝑥𝑥𝑡𝑡−1 )2 . The LRT can interpreted as a test

that ignores information contained in 𝑥𝑥𝑡𝑡 = 𝛾𝛾 + 𝜌𝜌𝑥𝑥𝑡𝑡−1 + 𝑒𝑒𝑡𝑡 . The t-test is therefore a solution

to the hypothesis testing problem when 𝑥𝑥𝑡𝑡 is I(0) and r is unknown, provided that the large-

sample approximation is sufficiently accurate.

Q-test

Now suppose that 𝜌𝜌 is known. The Neyman-Pearson Lemma implies that the most

powerful test against the simple alternative 𝛽𝛽 = 𝛽𝛽1 rejects the null if

2018, Kyungsun Kim

𝑇𝑇 [

= 2(𝛽𝛽1 − 𝛽𝛽0 )Σ𝑡𝑡=1 𝑟𝑟𝑡𝑡 − 𝛽𝛽𝑢𝑢𝑢𝑢 (𝑥𝑥𝑡𝑡 − 𝜌𝜌𝑥𝑥𝑡𝑡−1 )] − (𝛽𝛽12 − 𝛽𝛽02 )Σ𝑡𝑡=1

𝑇𝑇 2

𝑥𝑥𝑡𝑡−1 > 𝐶𝐶,

𝑇𝑇 2

where 𝛽𝛽𝑢𝑢𝑢𝑢 = 𝜎𝜎𝑢𝑢𝑢𝑢 /𝜎𝜎𝑒𝑒2 . However, since Σ𝑡𝑡=1 𝑥𝑥𝑡𝑡−1 is ancillary, the optimal conditional test is

UMP(uniformly most powerful) against one-sided alternatives (𝛽𝛽1 > 𝛽𝛽0 ) test can be

expressed as

𝑇𝑇

𝛴𝛴𝑡𝑡=1 𝑥𝑥𝑡𝑡−1 [𝑟𝑟𝑡𝑡 − 𝛽𝛽0 𝑥𝑥𝑡𝑡−1 − 𝛽𝛽𝑢𝑢𝑢𝑢 (𝑥𝑥𝑡𝑡 − 𝜌𝜌𝑥𝑥𝑡𝑡−1 )]

1 1 > 𝐶𝐶

𝑇𝑇 2 )2

𝜎𝜎𝑢𝑢 (1 − 𝛿𝛿 2 )2 (Σ𝑡𝑡=1 𝑥𝑥𝑡𝑡−1

Note that this inequality is reversed for left-sided alternatives 𝛽𝛽1 < 𝛽𝛽0 . UMP conditional on

𝑇𝑇 2

the ancillary statistic 𝛴𝛴𝑡𝑡=1 𝑥𝑥̅𝑡𝑡−1 is expressed as

𝑇𝑇

𝛴𝛴𝑡𝑡=1 𝑥𝑥̅𝑡𝑡−1 [𝑟𝑟𝑡𝑡 − 𝛽𝛽0 𝑥𝑥𝑡𝑡−1 − 𝛽𝛽𝑢𝑢𝑢𝑢 (𝑥𝑥𝑡𝑡 − 𝜌𝜌𝑥𝑥𝑡𝑡−1 )]

𝑄𝑄 (𝛽𝛽0 , 𝜌𝜌) = 𝑇𝑇 2 )1/2

𝜎𝜎𝑢𝑢 (1 − 𝛿𝛿 2 )1/2(𝛴𝛴𝑡𝑡=1 𝑥𝑥̅𝑡𝑡−1

When 𝛽𝛽0 = 0, 𝑄𝑄(𝛽𝛽0 , 𝜌𝜌) is the t-statistic that results from regressing 𝑟𝑟𝑡𝑡 − 𝛽𝛽𝑢𝑢𝑢𝑢 (𝑥𝑥𝑡𝑡 −

𝜌𝜌𝑥𝑥𝑡𝑡−1 ) onto a constant and 𝑥𝑥𝑡𝑡−1 . It collapses to the conventional t-statistic when 𝛿𝛿 = 0.

Since 𝑒𝑒𝑡𝑡 + 𝛾𝛾 = 𝑥𝑥𝑡𝑡 − 𝜌𝜌𝑥𝑥𝑡𝑡−1 , knowledge of 𝜌𝜌 allows us to subtract off the part of innovation

to returns that is correlated with the innovation to the predictor variable, resulting in a more

powerful test. If we let 𝜌𝜌� denote the OLS estimator of 𝜌𝜌, then the Q-statistic can also be

written as

𝑄𝑄(𝛽𝛽0 , 𝜌𝜌) = 𝑇𝑇 2 )1/2

𝜎𝜎𝑢𝑢 (1 − 𝛿𝛿 2 )1/2(𝛴𝛴𝑡𝑡=1 𝑥𝑥̅𝑡𝑡−1

Lewellen (2004) motivates the statistic by interpreting the term 𝛽𝛽𝑢𝑢𝑢𝑢 (𝜌𝜌� − 𝜌𝜌) as the “finite-

sample bias” of the OLS estimator. Assuming that 𝜌𝜌 ≤ 1, Lewellen tests the predictability of

returns using the statistic 𝑄𝑄 (𝛽𝛽0 , 1).

If we knew persistence, we could reduce noise by adding the innovation to the predictor

variable to the predictive regression, estimating

The additional regressor, (𝑥𝑥𝑡𝑡+1 − 𝜌𝜌𝑥𝑥𝑡𝑡 ) = ηt+1, is uncorrelated with the original regressor 𝑥𝑥𝑡𝑡

but correlated with the dependent variable 𝑟𝑟𝑡𝑡+1 . Thus we still get a consistent estimate of the

original predictive coefficient 𝛽𝛽, but with increased precision because we have controlled for

some of the noise in unexpected stock returns. Of course, in practice we do not know the

persistence coefficient 𝜌𝜌, but we can construct a confidence interval for it by inverting a unit

root test, that is, (𝜌𝜌, 𝜌𝜌). Thus, accordingly, we can obtain the confidence interval of 𝛽𝛽. (이

부분이 2016-1 중간고사 #5임) The test delivers particularly strong evidence for

predictability if we rule out a persistence coefficient 𝜌𝜌 > 1 on prior grounds.

2018, Kyungsun Kim

They reexamine the performance of variables that have been suggested to be good

predictors of the equity premium. And they find that by and large, these models have

predicted poorly both in-sample (IS) and out-of-sample (OOS) for 30 years now; these

models seem unstable or even spurious, as diagnosed by their out-of-sample predictions and

other statistics. They argue that the poor out-of-sample performance of predictive regressions

is a systemic problem. They find that historical average returns almost always generate

superior return forecasts.

OOS statistics

The OOS forecast uses only the data available up to the time at which the forecast is made.

Let 𝑒𝑒𝑁𝑁 denote the vector of rolling OOS errors from the historical mean model and 𝑒𝑒𝐴𝐴 denote

the vector of rolling OOS errors from the OLS model. Our OOS statistics are computed as

MSE 𝑇𝑇−𝑘𝑘

𝑅𝑅2 = 1 − MSE𝐴𝐴 , 𝑅𝑅�2 = 𝑅𝑅 2 − (1 − 𝑅𝑅2 ) × ( ),

𝑁𝑁 𝑇𝑇−1

MSE𝑁𝑁 −MSE𝐴𝐴

MSE − F = (𝑇𝑇 − ℎ + 1) × ( ),

MSE𝐴𝐴

where h is the degree of overlap (h=1 for no overlap). MSE-F is McCracken’s (2004) F-

statistic. It tests for equal MSE of the unconditional forecast and the conditional forecast (i.e.,

∆MSE = 0).

Table 1 shows the predictive performance of the forecasting models on annual forecasting

horizons.

2018, Kyungsun Kim

Contrast to Welch and Goyal (2008), Campbell and Thompson (2008) show that many

predictive regressions beat the historical average return, once weak restrictions are imposed

on the signs of coefficients and return forecasts. The out-of-sample explanatory power is

small, but nonetheless is economically meaningful for mean-variance investors.

Historical means vs. other variables such as E/P, D/P, inflation, t-bill, term structure,

and default risk premium

2018, Kyungsun Kim

𝑅𝑅2 statistic that can be compared with the in-sample 𝑅𝑅2 statistic. This is computed as

𝑇𝑇 (

2

Σ𝑡𝑡=1 𝑟𝑟𝑡𝑡 − 𝑟𝑟�𝑡𝑡 )2

𝑅𝑅𝑂𝑂𝑂𝑂 = 1 − 𝑇𝑇

Σ𝑡𝑡=1 (𝑟𝑟𝑡𝑡 − 𝑟𝑟̅𝑡𝑡 )2

where 𝑟𝑟�𝑡𝑡 is the fitted value from a predictive regression estimated through period 𝑡𝑡 − 1, and

𝑟𝑟̅𝑡𝑡 is the historical average return estimated through period 𝑡𝑡 − 1. If the out-of-sample 𝑅𝑅2 is

positive, then the predictive regression has lower average mean-squared prediction error than

the historical average return.

The out-of-sample performance of the predictor variables is mixed. The fifth column of

Table 1 shows that only two out of the four valuation ratios (the earnings yield and smoothed

earnings yield) and two out of the five interest-rate variables (the treasury bill rate and term

spread) deliver positive out-of-sample 𝑅𝑅2 statistics.

Consider two alternative restrictions that can be imposed on any theoretically motivated

forecasting regressions: ① the regression coefficient has the theoretically expected sign; and

② the fitted value of the equity premium is positive. Restricted regressions then perform

considerably better than these unpredicted regressions.

Table 2 shows that the last and most restrictive approach delivers the best out-of-sample

performance in monthly data.

Strong in-sample evidence and weak out-of-sample evidence are not necessarily suggesting

that in-sample tests are not reliable. Any out-of-sample analysis based on sample-splitting

involves a loss of information and hence lower power in small samples. As a result, an out-

of-sample test may fail to detect predictability that exists in population, whereas the in-

sample test correctly detects it. (See Kilian and Taylor, 2003, JIE)

2018, Kyungsun Kim

✓ Cochrane (2011)

Previously, returns were thought to be unpredictable, with variation in D/P due to variation

in expected cash flows. Now it seems all price-dividend variation corresponds to discount-

rate variation.

𝑒𝑒

𝑅𝑅𝑡𝑡→𝑡𝑡+𝑘𝑘 = 𝑎𝑎 + 𝑏𝑏 × 𝐷𝐷𝑡𝑡 /𝑃𝑃𝑡𝑡 + 𝜀𝜀𝑡𝑡+𝑘𝑘

The 1-year regression forecast does not seem that important (R2 = 9%). However, long

horizons are most interesting because they tie predictability to volatility and the nature of

price movements. Recall Campbell-Shiller (1988) approximate present value identity,

where 𝑑𝑑𝑝𝑝𝑡𝑡 ≡ 𝑑𝑑𝑡𝑡 − 𝑝𝑝𝑡𝑡 = log(𝐷𝐷𝑡𝑡 /𝑃𝑃𝑡𝑡 ), 𝑟𝑟𝑡𝑡+1 ≡ log 𝑅𝑅, and 𝜌𝜌 ≈ 0/96 is a constant of

approximation.

Now, consider regressions of weighted long-run returns and dividend growth on dividend

yields:

𝑘𝑘−1

(𝑘𝑘) 𝑟𝑟

� 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑡𝑡+1+𝑗𝑗 � = 𝑎𝑎𝑟𝑟 + 𝑏𝑏𝑟𝑟 𝑑𝑑𝑝𝑝𝑡𝑡 + 𝜀𝜀𝑡𝑡+𝑘𝑘𝑘𝑘

𝑗𝑗=0

𝑘𝑘−1

(𝑘𝑘) 𝑑𝑑

� 𝜌𝜌 𝑗𝑗 �∆𝑑𝑑𝑡𝑡+1+𝑗𝑗 � = 𝑎𝑎𝑑𝑑 + 𝑏𝑏𝑑𝑑 𝑑𝑑𝑝𝑝𝑡𝑡 + 𝜀𝜀𝑡𝑡+𝑘𝑘𝑘𝑘

𝑗𝑗=0

(𝑘𝑘) 𝑑𝑑𝑑𝑑

𝑑𝑑𝑝𝑝𝑡𝑡+𝑘𝑘 = 𝑎𝑎𝑑𝑑𝑑𝑑 + 𝑏𝑏𝑑𝑑𝑑𝑑 𝑑𝑑𝑝𝑝𝑡𝑡 + 𝜀𝜀𝑡𝑡+𝑘𝑘𝑘𝑘

By regressing both sides of the identity (4) on 𝑑𝑑𝑝𝑝𝑡𝑡 , these long-run regression coefficients must

add up to one:

1 ≈ 𝑏𝑏𝑟𝑟 − 𝑏𝑏𝑑𝑑 + 𝜌𝜌 𝑘𝑘 𝑏𝑏𝑑𝑑𝑑𝑑 (5)

If everything is i.i.d., dividend yields would never vary in the first place. Expected future

returns and dividend growth would never change. Since dividend yields vary, they must

forecast long-run returns, long-run dividend growth, or a “rational bubble” of ever-higher

prices.

2018, Kyungsun Kim

𝑘𝑘−1 𝑘𝑘−1

𝑗𝑗=0 𝑗𝑗=0

(𝑘𝑘) (𝑘𝑘)

𝑏𝑏𝑑𝑑 is close to zero since D/P ratio is uncorrelated with future dividend growth, and 𝜌𝜌 𝑘𝑘 𝑏𝑏𝑑𝑑𝑑𝑑

is negligible in long-run. Therefore, the true meaning of return predictability is that it is just

(𝑘𝑘)

enough to account for the price volatility (𝑏𝑏𝑟𝑟 ≈ 1).

Based on the idea that returns are not predictable, we would have supposed that high prices

relative to current dividends reflect expectations that dividends will rise in the future, and so

forecast higher dividend growth. That pattern is completely absent. Instead, high prices

relative to current dividends entirely forecast low returns.

✓ Campbell (1991)

The author decomposes unexpected return into cash flow component and discount rate

component based on log-linearization of Campbell and Shiller (1988) and estimates each

component using VAR approach.

𝑗𝑗=0 𝜌𝜌 ∆𝑑𝑑𝑡𝑡+1+𝑗𝑗 − (𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 ) ∑𝑗𝑗=1 𝜌𝜌 ℎ𝑡𝑡+1+𝑗𝑗 (6)

where ℎ𝑡𝑡+1 denotes the log real return on a stock held from the end of period t to the end of

period t+1, and 𝑑𝑑𝑡𝑡+1 denotes the log real dividend paid during period t+1. Surprising

implication from (6) is that better information about future dividends lowers not only price

level but also volatility of returns.

Let us define 𝑣𝑣ℎ,𝑡𝑡+1 to be the unexpected component of the stock return ℎ𝑡𝑡+1 :

Let us define 𝜂𝜂𝑑𝑑,𝑡𝑡+1 and 𝜂𝜂ℎ,𝑡𝑡+1 , respectively, to be the term in equation (6) which represents

news about cash flows and news about future returns:

2018, Kyungsun Kim

𝑗𝑗=0

∞

𝑗𝑗=1

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+1 is the revision in expectations (news) about current and future cash flow, and 𝑁𝑁𝐷𝐷𝐷𝐷,𝑡𝑡+1

is the revision in expectations (news) about future discount rate. Unexpected stock return is

broken down into components which are attributable to these two types of news.

Define 𝑢𝑢𝑡𝑡+1 to be the innovation at time t+1 in the one-period-ahead expected return:

If the expected return follows a univariate time series process, then 𝜂𝜂ℎ,𝑡𝑡+1 is an exact function

of 𝑢𝑢𝑡𝑡+1 . The AR(1) case is

which implies

𝜌𝜌𝑢𝑢𝑡𝑡+1 𝑢𝑢𝑡𝑡+1

𝜂𝜂ℎ,𝑡𝑡+1 = ≈

1 − 𝜌𝜌𝜌𝜌 1 − 𝜙𝜙

⇒ Price implication

Since 𝜌𝜌 is a number very close to one, this equation says that a 1% increase in the

expected return today is associated with a capital loss of about 2% if the AR coefficient is

0.5, a loss about 4% if the AR coefficient is 0.75, and a loss of about 10% if the AR

coefficient is 0.9. In other words, the expected return may have a very small volatility yet

may still have a very large effect on the stock price if it is highly persistent.

Denote 𝐳𝐳𝑡𝑡+1 which has k elements, a demeaned vector of log return, log D/P, and log risk-

free rate. Assume that the vector 𝐳𝐳𝑡𝑡+1 follows VAR(1):

2018, Kyungsun Kim

where matrix A is known as the companion matrix of the VAR. Denote a k-element vector 𝒆𝒆1 ′,

whose first element is 1 and other elements are all 0. This vector picks out the real stock return

ℎ𝑡𝑡+1 from the vector 𝐳𝐳𝑡𝑡+1 : ℎ𝑡𝑡+1 = 𝒆𝒆1 ′𝐳𝐳𝑡𝑡+1 and 𝑣𝑣ℎ,𝑡𝑡+1 = 𝒆𝒆1 ′𝝎𝝎𝑡𝑡+1 . The VAR(1) generates

simple multi-period forecasts of future returns:

It follows that the discounted sum of revisions in forecast returns can be written as

∞

∞

𝜂𝜂ℎ,𝑡𝑡+1 ≡ (𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 ) � 𝜌𝜌 𝑗𝑗 ℎ𝑡𝑡+1+𝑗𝑗 = 𝒆𝒆1′ 𝛴𝛴𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑨𝑨𝑗𝑗 𝝎𝝎𝑡𝑡+1

𝑗𝑗=1

= 𝒆𝒆1′ 𝜌𝜌𝑨𝑨(𝑰𝑰 − 𝜌𝜌𝑨𝑨)−1 𝝎𝝎𝑡𝑡+1

= 𝝀𝝀′ 𝝎𝝎𝑡𝑡+1

where 𝝀𝝀′ is defined to equal 𝒆𝒆1′ 𝜌𝜌𝑨𝑨(𝑰𝑰 − 𝜌𝜌𝑨𝑨)−1 , a nonlinear function of the VAR coefficients.

From (7),

These expressions can be used to decompose the variance of the unexpected stock return 𝑣𝑣ℎ,𝑡𝑡+1 ,

into the variance of the news about cash flow, 𝜂𝜂𝑑𝑑,𝑡𝑡+1 , and a covariance term:

One natural way to summarize persistence is by the variability of the innovation in the

expected present value of future returns, relative to the variability of the innovation in the one-

period-ahead expected return (𝑢𝑢𝑡𝑡+1 ). Suppose that one-period ahead expected return follows a

VAR(1) process. Then, the innovation can be defined as 𝑢𝑢𝑡𝑡+1 ≡ 𝒆𝒆1′ (𝐸𝐸𝑡𝑡+1 𝒛𝒛𝑡𝑡+2 − 𝑨𝑨𝐸𝐸𝑡𝑡 𝒛𝒛𝑡𝑡+1 ) =

𝒆𝒆1′ (𝑨𝑨𝒛𝒛𝑡𝑡+1 − 𝑨𝑨2 𝒛𝒛𝑡𝑡 ) = 𝒆𝒆1′ 𝑨𝑨𝝎𝝎𝑡𝑡+1 . Thus, define the VAR persistence measure 𝑃𝑃ℎ as

𝜎𝜎�𝜂𝜂ℎ,𝑡𝑡+1 � 𝜎𝜎(𝝀𝝀′𝝎𝝎𝑡𝑡+1 )

𝑃𝑃ℎ ≡ =

𝜎𝜎 (𝑢𝑢𝑡𝑡+1 ) 𝜎𝜎(𝒆𝒆1′ 𝑨𝑨𝝎𝝎𝑡𝑡+1 )

Another way to describe the statistic 𝑃𝑃h is to say that a typical 1% positive innovation in

the expected return will cause a 𝑃𝑃h % capital loss on the stock. In the univariate AR(1) case,

𝑃𝑃h would just equal 𝜌𝜌/(1 − 𝜙𝜙𝜙𝜙), or approximately 1/(1 − 𝜙𝜙).

Once we estimate 𝐴𝐴̂ by running separate regression by each equation, we can first calculate

discount news component and then recover cash flow news can be identified through

∞ ∞

𝑁𝑁𝐷𝐷𝐷𝐷,𝑡𝑡+1 = � 𝜌𝜌 𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 )𝑟𝑟𝑡𝑡+1+𝑗𝑗 = � 𝜌𝜌 𝑗𝑗 𝒆𝒆1′ 𝑨𝑨𝑗𝑗 𝜖𝜖𝑡𝑡+1 = 𝒆𝒆1′ 𝜌𝜌𝑨𝑨(𝑰𝑰 − 𝜌𝜌𝑨𝑨)−1 𝜖𝜖𝑡𝑡+1

𝑗𝑗 (

𝑗𝑗=1 𝑗𝑗=1

2018, Kyungsun Kim

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+1 = 𝑟𝑟𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 𝑟𝑟𝑡𝑡+1 + 𝑁𝑁𝐷𝐷𝐷𝐷,𝑡𝑡+1 = 𝒆𝒆1′ [𝐼𝐼 + 𝜌𝜌𝑨𝑨(𝑰𝑰 − 𝜌𝜌𝑨𝑨)−1 ]𝜖𝜖𝑡𝑡+1

Using variance decomposition at aggregate level, DR news accounts for over 77%, cash flow

news about 13 %, covariance between cash flow news and discount rate news (negative) about

10% of total variance of unexpected stock returns in later subperiod (1952-1988).

However, constant expected return hypothesis may be rejected, but does not necessarily

mean that market is inefficient because it may be due to time-varying risk aversion.

✓ Vuolteenaho (2002)

Clean Surplus Identiy

Earnings (X), dividends, and book equity must satisfy the clean-surplus identity:

𝐵𝐵𝑡𝑡 = 𝐵𝐵𝑡𝑡−1 + 𝑋𝑋𝑡𝑡 − 𝐷𝐷𝑡𝑡

Under this assumption, Voulteenaho (2000) derives a model for the log B/M (denoted by 𝜃𝜃):

∞ ∞

𝑗𝑗

𝑗𝑗=0 𝑗𝑗=0

where ROE is denoted by 𝑒𝑒𝑡𝑡 = log(1 + 𝑋𝑋𝑡𝑡 /𝐵𝐵𝑡𝑡−1 ), the excess log stock return by 𝑟𝑟𝑡𝑡 =

log(1 + 𝑅𝑅𝑡𝑡 + 𝐹𝐹𝑡𝑡 ) − 𝑓𝑓𝑡𝑡 , the simple excess return by 𝑅𝑅𝑡𝑡 , the interest rate by 𝐹𝐹𝑡𝑡 , log one plus

the interest rate by 𝑓𝑓𝑡𝑡 , and a constant plus the approximation error by 𝑘𝑘. Then, we can

decompose the unexpected stock return into an expected-return component and a cash-flow

component, along the lines of Campbell (1991). (다만, zero-dividend company가 많으니까

fundamental component of return의 proxy로 dividend 대신 ROE로 대체할 필요성;

Rather, recommend payout ratio even at individual level; Larrain & Yogo (2008): The

appropriate measure of cash flow for valuing corporate assets is net payout, which is the sum

of dividends, interest, and net repurchases of equity and debt. Variation in net payout yield,

the ratio of net payout to asset value, is mostly driven by movements in expected cash flow

growth, instead of movements in discount rates. Net payout yield is less persistent than

dividend yield and implies much smaller variation in long-horizon discount rates. Therefore,

movements in the value of corporate assets can be justified by changes in expected future

2018, Kyungsun Kim

cash flow.)

∞ ∞

𝑗𝑗=0 𝑗𝑗=1

where ∆𝐸𝐸𝑡𝑡 denotes change in expectations from 𝑡𝑡 − 1 to 𝑡𝑡 (i.e., 𝐸𝐸𝑡𝑡 (∙) − 𝐸𝐸𝑡𝑡−1 (∙)). Defining

the two return component as cash-flow news(𝑁𝑁𝑐𝑐𝑐𝑐 ) and expected-return news(𝑁𝑁𝑟𝑟 ) yields

𝑁𝑁𝑐𝑐𝑐𝑐,𝑡𝑡 ≡ ∆𝐸𝐸𝑡𝑡 ∑∞ 𝑗𝑗

𝑗𝑗=0 𝜌𝜌 �𝑒𝑒𝑡𝑡+𝑗𝑗 − 𝑓𝑓𝑡𝑡+𝑗𝑗 �+𝜅𝜅𝑡𝑡

∞

𝑗𝑗=1

Since 𝑟𝑟𝑡𝑡 − 𝐸𝐸𝑡𝑡−1 𝑟𝑟𝑡𝑡 = 𝑁𝑁𝑐𝑐𝑐𝑐,𝑡𝑡 − 𝑁𝑁𝑟𝑟,𝑡𝑡 , the unexpected excess stock return can be high if either

expected future excess returns decrease and/or expected future excess ROEs (i.e., ROE less

interest rate) increase. The approximation error of the return-news equation is denoted by 𝜅𝜅𝑡𝑡 ≡

∆𝐸𝐸𝑡𝑡 (𝑘𝑘𝑡𝑡−1 ).

The unexpected-return variance is then decomposed into tree components:

이것은 𝑟𝑟𝑡𝑡 − 𝐸𝐸𝑡𝑡−1 𝑟𝑟𝑡𝑡 = 𝜀𝜀𝑡𝑡 , 즉 residual을 decompose해서 각각의 variance를 구하고

수 있다.

Let 𝑧𝑧𝑖𝑖,𝑡𝑡 be a vector of firm-specific state variable describing a firm i at time t, and

particularly, the first element of 𝑧𝑧𝑖𝑖,𝑡𝑡 is the firm’s stock return, defined as market-adjusted log

return. Assume an individual firm’s state vector follows VAR(1):

The VAR coefficient matrix 𝐀𝐀 is assumed to be constant, both over time and across firms.(여

기서 A는 common coefficient from pooled data이다. Small firm과 large firm으로 나눴을

2018, Kyungsun Kim

coefficient를 얻었다. 그러나 𝑢𝑢𝑖𝑖,𝑡𝑡 는 각각 다 다름.) The error term 𝑢𝑢𝑖𝑖,𝑡𝑡 is assumed to

have a covariate matrix Σ and be independent of everything known at 𝑡𝑡 − 1.

conditional variance, use of correct weight generates BLUE. However, we do not know the

functional form. In this case, even though standard error may be slightly larger than that of

WLS, using heteroskedasticity robust standard error with LS estimator may be better. If you

are concerned about possible cross-correlation across firms, LS estimator with cluster standard

error may be better.

Tetlock (2014): I compute the full sample coefficient estimate as the time series average of

the daily cross-section regression coefficients. Using an unweighted average disregards the

standard error of each daily coefficient estimate, which is generally inefficient. Instead, I

weight each daily coefficient estimate using the inverse of the variance of the daily coefficient,

as suggested in Ferson and Harvey (1999).

Common coefficient matrix is estimated over pooled sample, with each cross-section is

weighted equally by deflating the data for each frim-year by the number of firms within the

corresponding cross-section. This WLS approach does not bias coefficients but does bias

standard errors. If heteroskedasticity in standard error is disconcerting, then LS estimator with

White SE (heteroskedasticity-robust) is appropriate. If we are concerned of cross-firm

correlation, LS with clustered SE by time. Momentum effect is observed in AR coefficient

between current and past returns (0.1182), B/M effect between current return and past B/M

(0.0477), and PEAD effect between current return and past profitability (0.1464).

2018, Kyungsun Kim

Campbell (1991) simplifies the expressions: Expected-return news can be expressed as 𝝀𝝀′ 𝒖𝒖𝑖𝑖,𝑡𝑡

and cash-flow news as (𝒆𝒆1′ + 𝝀𝝀′)𝒖𝒖𝑖𝑖,𝑡𝑡 .

Total variance can be decomposed into discount rate component, and cash flow component,

which constitutes about 25% and 75%, respectively.

𝑣𝑣𝑣𝑣𝑣𝑣(𝑁𝑁𝑟𝑟 ) = 𝝀𝝀′𝚺𝚺𝚺𝚺

2018, Kyungsun Kim

Large firms’ variance composition is nearly CF: DR=8:1 with no correlation between CF

news and DR news. For small firms, it is 2.5:1, and the correlation btw CF news and DR news

is positive and high. This clouds the contemporaneous relation between current return and CF

news. We can interpret b less than 1 as under-reaction, and b greater than 1 as overreaction.

While large firms’ return has b=1, small firms’ return has b=0.7, which may be due to

conflicting effect of CF and DR on return.

( 𝑟𝑟𝑡𝑡 = 𝑎𝑎 + 𝑏𝑏 ∙ 𝑁𝑁𝐶𝐶𝐶𝐶 + 𝑛𝑛 에서 𝑏𝑏 < 1 이면 under-reaction이고 𝑏𝑏 > 1 이면 overreaction으로

2018, Kyungsun Kim

도 있다.)

Cross section variation in the ratio of cash-flow variance to total variance implies that large

firms may represent better diversified investment projects.

“Inefficient at macro-level, efficient at micro-level.”

(*) VAR predictive regressions are sensitive to sample period, the choice of predictive (state)

variables,

The firm’s intertemporal budget constraint

• 𝑌𝑌𝑡𝑡 : Earnings net of taxes and depreciation in period t.

• 𝐶𝐶𝑡𝑡 : Net payout, or the net cash outflow from the firm, in period t, composed of dividends,

interest, equity repurchase net of issuance, and debt repurchase net of issuance.

• 𝐼𝐼𝑡𝑡 : Investment net of depreciation in period t.

• 𝐴𝐴𝑡𝑡 : market value of assets at the end of period t.

• 𝐶𝐶𝑡𝑡 /𝐴𝐴𝑡𝑡 : Net payout yield at the end of period t.

• 𝑅𝑅𝑡𝑡+1 = 1 + 𝑌𝑌𝑡𝑡+1 /𝐴𝐴𝑡𝑡 : Return on assets in period t+1.

The flow of funds identity states that the sources of funds must equal the uses of funds,

Thus, we have:

They adopt the framework of log-linear present value model of Campbell and Shiller (1988),

the Cordon growth model that allows for time variation in discount rates and expected cash

flow growth. Let lowercase letters denote the log of the corresponding uppercase variables.

Let 𝑣𝑣𝑡𝑡 = log(𝐶𝐶𝑡𝑡 /𝐴𝐴𝑡𝑡 ). Log-linear approximation of equation (8) leads to a difference equation

for net payout yield

where 𝜌𝜌 = 1/(1 + exp{𝐄𝐄[𝑣𝑣𝑡𝑡 ]}), and all the variables are assumed to be de-meaned.

일단 𝑟𝑟𝑡𝑡+1 은 forecasted value임 (rt+1 = E𝑡𝑡 [𝑟𝑟𝑡𝑡+1 ] = 𝝓𝝓𝑟𝑟𝑡𝑡 = 𝜙𝜙�11 𝑟𝑟𝑡𝑡 + 𝜙𝜙�12 ∆𝑐𝑐𝑡𝑡 + 𝜙𝜙�13 𝜌𝜌𝑣𝑣�𝑡𝑡 ).

2018, Kyungsun Kim

것이어야 한다. 또한, 이러한 constraint(Eq. (9))는 possible bias (error term 간의

correlation: the unexpected return, 𝑢𝑢𝑡𝑡 , and is negatively correlated with the innovation in

dividend yield, 𝑣𝑣𝑡𝑡 )을 handle하려는 시도임.

where

𝐻𝐻

𝑟𝑟𝑡𝑡 (𝐻𝐻 ) = Σ𝑠𝑠=1 𝜌𝜌 𝑠𝑠−1 𝑟𝑟𝑡𝑡+𝑠𝑠

𝐻𝐻

∆𝑐𝑐𝑡𝑡 (𝐻𝐻 ) = Σ𝑠𝑠=1 𝜌𝜌 𝑠𝑠−1 ∆𝑐𝑐𝑡𝑡+𝑠𝑠

𝑣𝑣𝑡𝑡 (𝐻𝐻 ) = 𝜌𝜌 𝐽𝐽 𝑣𝑣𝑡𝑡+𝐻𝐻

∞

𝑣𝑣𝑡𝑡 = Σ𝑠𝑠=1 𝜌𝜌 𝑠𝑠−1 (𝑟𝑟𝑡𝑡+𝑠𝑠 − ∆𝑐𝑐𝑡𝑡+𝑠𝑠 ) (11)

The convergence of the sum is assured by the assumption that net payout yield is stationary

(i.e., net payout and asset value are cointegrated).

Eq. (11) also holds ex ante as a present-value model

∞

𝑣𝑣𝑡𝑡 = E𝑡𝑡 Σ𝑠𝑠=1 𝜌𝜌 𝑠𝑠−1 (𝑟𝑟𝑡𝑡+𝑠𝑠 − ∆𝑐𝑐𝑡𝑡+𝑠𝑠 ) (12)

Equation (12) says that net payout yield is high when expected asset returns are high or

expected cash flow growth is low. If movements in discount rates were perfectly offset by

movements in expected cash flow growth, then net payout yield would be constant.

Therefore, net payout yield must forecast independent (as opposed to common) variation in

asset returns or net payout growth.

Rearraging Eq. (12),

∞ ∞

𝑎𝑎𝑡𝑡 = 𝑐𝑐𝑡𝑡 + E𝑡𝑡 Σ𝑠𝑠=1 𝜌𝜌 𝑠𝑠−1 ∆𝑐𝑐𝑡𝑡+𝑠𝑠 − E𝑡𝑡 Σ𝑠𝑠=1 𝜌𝜌 𝑠𝑠−1 𝑟𝑟𝑡𝑡+𝑠𝑠 (13)

The first two terms on the right side of this equation can be interpreted as expected net payout

under a constant discount rate. The last term on the right side is long-horizon discount rates,

which measures the magnitude of deviation from the constant discount rate present-value

model. We use Eq. (13) to assess whether changes in expected future cash flow justify

movements in asset value.

The present-value model allows us to measure the variation in unexpected asset returns.

Subtracting the expectation of Eq. (11) in period t from its expectation in period t+1,

∞ ∞

𝑠𝑠−1

𝑟𝑟𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 𝑟𝑟𝑡𝑡+1 = −(𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 ) � 𝜌𝜌 𝑟𝑟𝑡𝑡+𝑠𝑠 + (𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 ) � 𝜌𝜌 𝑗𝑗−1 ∆𝑐𝑐𝑡𝑡+𝑗𝑗

𝑠𝑠=2 𝑠𝑠=1

This equation takes the view of an investor who rationalizes realized asset returns through

changes in discount rates and changes in expected cash flow growth. Asset return is

2018, Kyungsun Kim

unexpectedly high when discount rates fall or expected cash flow growth rises.

VAR estimation

Let 𝑥𝑥𝑡𝑡 = (𝑟𝑟𝑡𝑡 , ∆𝑐𝑐𝑡𝑡 , 𝑣𝑣𝑡𝑡 )′, assuming the variables are de-meaned so that E[𝑥𝑥𝑡𝑡 ] = 0. The VAR

model is

Let I denote an identity matrix of dimension three, and let 𝑒𝑒𝑖𝑖 denote the ith column of the

identity matrix. The present-value model, that is, the expectation of Eq. (9) in period t,

requires the coefficients satisfy the linear restrictions

The VAR model is therefore overidentified (4 restrictions with 3 parameters). We test the

overidentifying restrictions of the model through the J-test (Hansen, 1982). We estimate the

model by continuous-updating generalized method of moments(GMM) without imposing

normality condition on error tierm with 9 moment condition between error terms and regressor,

and one additional condition. The model is correctly specified in that it incorporates the

correlation between the error terms using the identity condition.

2018, Kyungsun Kim

Net payout growth has a mean of 3.8% and a standard deviation of 38.4%, which is much

more volatile than dividend growth. That is, if we use payout instead of dividend, excess

volatility paradox disappears!

Possible bias?

⇒ Model is correctly specified here incorporating all relevant information among variables.

For example, given 𝑣𝑣𝑡𝑡 and ∆𝑐𝑐𝑡𝑡+1 , if 𝑟𝑟𝑡𝑡+1 goes up, 𝑣𝑣𝑡𝑡+1 should go down.

“Even at aggregate level, excess volatility may not be observed. Stock repurchase contains

market timing component, thus the results are inconclusive.”

2018, Kyungsun Kim

Using direct cash flow forecasts, we show that stock returns have a significant cash flow

news component whose importance increases with the investment horizon.

A price change can be decomposed into two pieces: (1) “CF news,” defined as the price

change holding the implied cost of capital (ICC) constant, and (2) “DR news,” defined as the

price change holding the cash flow forecasts constant.

The equity value is the present value of future dividends and a terminal value:

𝑇𝑇

𝐹𝐹𝐸𝐸𝑡𝑡+𝑘𝑘 (1 − 𝑏𝑏𝑡𝑡+𝑘𝑘 ) 𝐹𝐹𝐸𝐸𝑡𝑡+𝑇𝑇+1

𝑃𝑃𝑡𝑡 = Σ𝑘𝑘=1 + = 𝑓𝑓(𝑐𝑐𝑡𝑡 , 𝑞𝑞𝑡𝑡 )

(1 + 𝑞𝑞𝑡𝑡 ) 𝑘𝑘 𝑞𝑞𝑡𝑡 (1 + 𝑞𝑞𝑡𝑡 )𝑇𝑇

where 𝑃𝑃𝑡𝑡 is the stock price, 𝐹𝐹𝐸𝐸𝑡𝑡+𝑘𝑘 is the earnings forecast k years ahead, 𝑏𝑏𝑡𝑡+𝑘𝑘 is the

plowback rate (i.e. 1 − 𝑏𝑏𝑡𝑡+𝑘𝑘 is the payout ratio), and 𝑞𝑞𝑡𝑡 is the ICC.

The proportional price difference or capital gain return (Retx) between t+j and t is

𝑃𝑃𝑡𝑡+𝑗𝑗 − 𝑃𝑃𝑡𝑡

𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑗𝑗 =

𝑃𝑃𝑡𝑡

𝑓𝑓�𝑐𝑐 𝑡𝑡+𝑗𝑗 , 𝑞𝑞𝑡𝑡+𝑗𝑗 � − 𝑓𝑓 (𝑐𝑐 𝑡𝑡 , 𝑞𝑞𝑡𝑡 )

=

𝑃𝑃𝑡𝑡

= 𝐶𝐶𝐹𝐹𝑗𝑗 + 𝐷𝐷𝑅𝑅𝑗𝑗

where:

𝑓𝑓�𝑐𝑐 𝑡𝑡+𝑗𝑗 , 𝑞𝑞𝑡𝑡+𝑗𝑗 � − 𝑓𝑓�𝑐𝑐 𝑡𝑡 , 𝑞𝑞𝑡𝑡+𝑗𝑗 � 𝑓𝑓�𝑐𝑐 𝑡𝑡+𝑗𝑗 , 𝑞𝑞𝑡𝑡 � − 𝑓𝑓 (𝑐𝑐 𝑡𝑡 , 𝑞𝑞𝑡𝑡 )

𝐶𝐶𝐹𝐹𝑗𝑗 = ( + )/2

𝑃𝑃𝑡𝑡 𝑃𝑃𝑡𝑡

𝑓𝑓�𝑐𝑐 𝑡𝑡 , 𝑞𝑞𝑡𝑡+𝑗𝑗 � − 𝑓𝑓 (𝑐𝑐 𝑡𝑡 , 𝑞𝑞𝑡𝑡 ) 𝑓𝑓�𝑐𝑐 𝑡𝑡+𝑗𝑗 , 𝑞𝑞𝑡𝑡+𝑗𝑗 � − 𝑓𝑓�𝑐𝑐 𝑡𝑡+𝑗𝑗 , 𝑞𝑞𝑡𝑡 �

𝐷𝐷𝑅𝑅𝑗𝑗 = ( + )/2

𝑃𝑃𝑡𝑡 𝑃𝑃𝑡𝑡

It is labeled as CF news because the numerator is calculated by holding the discount rate

constant, and 𝐶𝐶𝐹𝐹𝑗𝑗 captures the price change driven primarily by the changing CF

expectations from t to t +j .

It is important to note that our decomposition is different from the more standard log-linear

return decomposition in Campbell and Shiller (1988). (Campbell and Shiller (1988)에서는

CF와 DR이 unexpected return을 설명하고, log-linearlization을 통해 return variation을

present value formula로 approximate 했지만, Chen et al. (2013)는 nonlinearity가 ICC에

내재되어 있으며, realized price change를 씀. 그러나 unexpected return과 realized price

change의 상관관계가 크기 때문에 두 논문의 implementation이 달라도 비슷한

inference가 가능하다.)

1= +

𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑡𝑡 ) 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑡𝑡 )

2018, Kyungsun Kim

𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑡𝑡 )

is the slope coefficient of regressing 𝐶𝐶𝐹𝐹𝑡𝑡 on 𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑡𝑡 ; 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑡𝑡 )

is the

slope coefficient of regressing 𝐷𝐷𝑅𝑅𝑡𝑡 on 𝑅𝑅𝑅𝑅𝑅𝑅𝑥𝑥𝑡𝑡 . In other words, to understand the portion of

capital gain return variance that is driven by CF news and DR news, one only needs to

regress CF and DR news on the capital gain returns, and draw inferences based on the slope

coefficients. (이때 coefficient의 합이 1에 가까운지 보는 것이 model이 잘 되었는지

확인하는 또 하나의 방법일 수 있다.)

2018, Kyungsun Kim

At aggregate level (1 quarter), CF news account only about 16% of whereas DR news

takes up 84% of return variance. At firm-level (1 quarter), results are similar (CF 19%, DR

81%) which contradicts the findings of Vuolteenaho (2002). Relative importance of CF news

increase and DR news decrease with investment horizon. In 12 quarter horizon, CF news

accounts for 60% of return variance at aggregate level, and 68% at firm level. This is consistent

with intuition that CF news has permanent impact of price whereas effect of DR news is

transitory.

(Ex) Negative news on discount rate (increase in discount rate) → stock price

decreases → current low realized return will be offset by high future returns → Thus relative

The finding that there is only a limited relative cash flow/discount rate diversification

effect when moving from individual firms to the aggregate portfolio provides a stark contrast

to the prevailing view (Vuolteenaho 2002) that, because of diversification, cash flow news

dominates at the firm level but discount rate news dominates at the aggregate level. We

argue, however, that the cash flow diversification effect is likely overstated because the panel

regressions in Vuolteenaho (2002) do not control for the firm-fixed effects.

Cross-sectional heterogeneity of cash flows is persistent and predictable. Therefore, it is

easy to find that CF news dominates whenever panel data are studied. In time-series dimension,

however, CF news are less predictable than discount rates. This explains why DR news is found

to be more important at firm level. Prevailing conclusion of Campbell (1991) and Vuolteenaho

(2002) is the result of mixing strong cross-sectional cash flow predictability (at firm level) with

weak time-series cash flow predictability (at market level). This paper runs time-series

regressions by-firm. For the period of 1985–2010, cash flow news explains 48% of stock return

at the firm level over the one-year horizon, a result very comparable to that using the ICC

method.

A major limitation

DR news captures the residual news. Thus, the success of the model depend on how accurate

CF news is (quality of analyst forecast about cash flow). Moreover, the reliance on terminal

growth assumption (steady state growth rate in calculating terminal value in the PDV) poses

some weakness.

(*) We cannot correct for time effect in regressor and residual (cross-firm correlation), which

may bias standard error downwards.

2018, Kyungsun Kim

Source of return predictability

Stock returns are correlated with contemporaneous earnings growth, dividend growth,

future real activity, and other cash-flow proxies. The correlation between cash-flow proxies

and stock returns may arise from association of cash-flow proxies with one-period expected

returns, cash-flow news, and/or expected-return news.

Using Campbell’s (1991) return decomposition, 𝑟𝑟𝑡𝑡 ≈ E𝑡𝑡−1 𝑟𝑟𝑡𝑡 + 𝑁𝑁𝑐𝑐𝑐𝑐,𝑡𝑡 − 𝑁𝑁𝑟𝑟,𝑡𝑡 , a typical

regression of returns on cash-flow proxies (D/P), 𝑟𝑟𝑡𝑡 = 𝑋𝑋𝑡𝑡 (𝜙𝜙 𝑇𝑇 )𝛽𝛽 + 𝜀𝜀𝑡𝑡 , can be split into three

component regressions,

𝑁𝑁𝑐𝑐𝑓𝑓,𝑡𝑡 = 𝑋𝑋𝑡𝑡 (𝜙𝜙 𝑇𝑇 )𝛽𝛽𝑁𝑁𝑐𝑐𝑐𝑐 + 𝜀𝜀𝑁𝑁𝑐𝑐𝑐𝑐,𝑡𝑡

−𝑁𝑁𝑟𝑟,𝑡𝑡 = 𝑋𝑋𝑡𝑡 (𝜙𝜙 𝑇𝑇 )𝛽𝛽−𝑁𝑁𝑟𝑟 + 𝜀𝜀𝑁𝑁𝑟𝑟 ,𝑡𝑡

Thus, we can think of the original regression as the sum of the three component regressions,

𝑟𝑟𝑡𝑡 = 𝑋𝑋𝑡𝑡 (𝜙𝜙 𝑇𝑇 ) �𝛽𝛽𝐸𝐸𝐸𝐸 + 𝛽𝛽𝑁𝑁𝑐𝑐𝑓𝑓 + 𝛽𝛽−𝑁𝑁𝑟𝑟 � + (𝜀𝜀𝐸𝐸𝐸𝐸,𝑡𝑡 + 𝜀𝜀𝑁𝑁𝑐𝑐𝑐𝑐,𝑡𝑡 + 𝜀𝜀𝑁𝑁𝑟𝑟 ,𝑡𝑡 )

Then, it is clear that the cash-flow proxies, 𝑋𝑋𝑡𝑡 , can explain the level of one-period expected

returns, cash-flow news, or expected-return news – or any combination of the three.

The 𝑅𝑅2 from a regression of returns on cash-flow proxies may overstate or understate the

importance of cash-flow news as a source of return variance.

They explore the role of fluctuations in the aggregate consumption-wealth ratio for

predicting stock returns. These fluctuations in the consumption-wealth ratio are strong

predictors of both real stock returns and excess returns over a Treasury bill rate. We also find

that this variable is a better forecaster of future returns at short and intermediate horizons than

is the dividend yield, the dividend payout ratio.

Let 𝑊𝑊𝑡𝑡 be aggregate wealth (human capital plus asset holdings) in period t. 𝐶𝐶𝑡𝑡 is

consumption and 𝑅𝑅𝑤𝑤,𝑡𝑡+1 is the net return on aggregate wealth. Consider a simple

accumulation equation for aggregate wealth:

Defining 𝑟𝑟 ≡ log(1 + 𝑅𝑅), Campbell and Mankiw (1989) derive an expression for the log

consumption-aggregate wealth ratio by taking a first-order Taylor expansion:

∞

𝑖𝑖

𝑐𝑐𝑡𝑡 − 𝑤𝑤𝑡𝑡 = 𝐸𝐸𝑡𝑡 � 𝜌𝜌𝑤𝑤 (𝑟𝑟𝑤𝑤,𝑡𝑡+𝑖𝑖 − ∆𝑐𝑐𝑡𝑡+𝑖𝑖 )

𝑖𝑖=1

− 𝑤𝑤 and we omit unimportant linearization constants in the

equations. This expression says that the log consumption–wealth ratio embodies rational

2018, Kyungsun Kim

forecasts of returns and consumption growth. Like the equation of log dividend-price ratio by

Campbell and Shiller (1988), the consumption-based expression does not predict which

variables on the right-hand side should be forecastable.

Consider the budget constraint of a consumer who invests his wealth in a single asset with a

time-varying risky return 1 + 𝑅𝑅𝑡𝑡 . The period-by-period budget constraint is

𝑤𝑤𝑡𝑡+1 − 𝑤𝑤𝑡𝑡 = 𝑟𝑟𝑡𝑡+1 + log(1 − 𝐶𝐶𝑡𝑡 /𝑊𝑊𝑡𝑡 ) = 𝑟𝑟𝑡𝑡+1 + log(1 − exp(𝑐𝑐𝑡𝑡 − 𝑤𝑤𝑡𝑡 )) (A.1)

The last term is a non-linear function of the log consumption-wealth ratio, 𝑐𝑐𝑡𝑡 − 𝑤𝑤𝑡𝑡 = 𝑥𝑥𝑡𝑡 . Now

we take a first-order Taylor expiation of this function, log(1 − exp(𝑥𝑥𝑡𝑡 )), around the point

𝑥𝑥𝑡𝑡 = 𝑥𝑥. The resulting approximation is

where the parameter 𝜌𝜌 ≡ 1 − exp(𝑥𝑥), a number a little less than one, and the constant 𝑘𝑘 ≡

log(𝜌𝜌) − (1 − 1/𝜌𝜌)log(1 − 𝜌𝜌). The parameter 𝜌𝜌 can also be interpreted as the average ratio

of invested wealth, 𝑊𝑊 − 𝐶𝐶, to total wealth, 𝑊𝑊. Substituting (A.2) into (A.1), we obtain:

This equation says that the growth rate of wealth is a constant, plus the log return on wealth,

less a small fraction (1 − 1/𝜌𝜌) of the log consumption-wealth ratio. The growth of wealth,

which appears on the left-hand side of equation (3.3), can be written in terms of the growth rate

of consumption and the change in the consumption-wealth ratio:

Substituting (A.3) into (3.3) and rearranging, we get a difference equation relating the log

consumption-wealth ratio today to the interest rate, the consumption growth rate, and the log

consumption-wealth ratio tomorrow:

∞

𝑐𝑐𝑡𝑡 − 𝑤𝑤𝑡𝑡 = Σj=1 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑡𝑡+𝑗𝑗 − ∆𝑐𝑐𝑡𝑡+𝑗𝑗 � + 𝜌𝜌𝜌𝜌/(1 − 𝜌𝜌) (3.4)

Equation (3.4) holds simply as a consequence of the agent’s intertemporal budget constraint

and therefore holds ex post, but it also holds ex ante. Accordingly, we can take conditional

2018, Kyungsun Kim

∞

𝑖𝑖

𝑐𝑐𝑡𝑡 − 𝑤𝑤𝑡𝑡 = 𝐸𝐸𝑡𝑡 � 𝜌𝜌𝑤𝑤 (𝑟𝑟𝑤𝑤,𝑡𝑡+𝑖𝑖 − ∆𝑐𝑐𝑡𝑡+𝑖𝑖 )

𝑖𝑖=1

− 𝑤𝑤 and we omit unimportant linearization constants in the

equations.

The above equation is of little use in empirical work because aggregate wealth, 𝑤𝑤𝑡𝑡 ,

includes human capital, which is not observable. Lettau and Ludvigson (2001a) address this

problem by reformulating the bivariate cointegration relation between 𝑐𝑐𝑡𝑡 and 𝑤𝑤𝑡𝑡 as a

trivariate cointegration relation involving three observable variables, namely 𝑐𝑐𝑡𝑡 , 𝑎𝑎𝑡𝑡 and 𝑦𝑦𝑡𝑡 ,

where 𝑎𝑎𝑡𝑡 is the log of nonhuman or asset wealth, and 𝑦𝑦𝑡𝑡 is log labor income. The resulting

empirical “proxy” for the log consumption-aggregate wealth ratio is a consumption-based

present-value relation involving future returns to asset wealth where 𝑎𝑎𝑡𝑡 is the log of

nonhuman or asset wealth, and 𝑦𝑦𝑡𝑡 is log labor income:

∞ 𝑖𝑖

𝑐𝑐𝑐𝑐𝑦𝑦𝑡𝑡 ≡ 𝑐𝑐𝑡𝑡 − 𝜔𝜔𝑎𝑎𝑡𝑡 − (1 − 𝜔𝜔)𝑦𝑦𝑡𝑡 = E𝑡𝑡 Σ𝑖𝑖=1 𝜌𝜌𝑤𝑤 (𝜔𝜔𝑟𝑟𝑎𝑎,𝑡𝑡+𝑖𝑖 − ∆𝑐𝑐𝑡𝑡+𝑖𝑖 + (1 − 𝜔𝜔)∆𝑦𝑦𝑡𝑡+1+𝑖𝑖 )

where 𝜔𝜔 is the average share of asset wealth, 𝐴𝐴𝑡𝑡 , in aggregate wealth, 𝑊𝑊𝑡𝑡 , and 𝑟𝑟𝑎𝑎,𝑡𝑡 is the

log return to asset wealth.

The above equation is of little use in empirical work because aggregate wealth, 𝑤𝑤𝑡𝑡 , includes

human capital, which is not observable. Lettau and Ludvigson (2001a) address this problem by

reformulating the bivariate cointegration relation between 𝑐𝑐𝑡𝑡 and 𝑤𝑤𝑡𝑡 as a trivariate

cointegration relation involving three observable variables, namely 𝑐𝑐𝑡𝑡 , 𝑎𝑎𝑡𝑡 and 𝑦𝑦𝑡𝑡 , where 𝑎𝑎𝑡𝑡

is the log of nonhuman or asset wealth, and 𝑦𝑦𝑡𝑡 is log labor income, implying that ℎ𝑡𝑡 = 𝜅𝜅 +

𝑦𝑦𝑡𝑡 + 𝑧𝑧𝑡𝑡 , where 𝜅𝜅 is a constant and 𝑧𝑧𝑡𝑡 is a mean zero stationary random variable.

Let 𝐴𝐴𝑡𝑡 be asset holdings, and let 1 + 𝑅𝑅𝑎𝑎,𝑡𝑡 be its gross return. Aggregate wealth is therefore

𝑊𝑊𝑡𝑡 = 𝐴𝐴𝑡𝑡 + 𝐻𝐻𝑡𝑡 and log aggregate wealth may be approximated as

where 𝜔𝜔 equals the average share of asset holdings in total wealth, A/W.

Then we obtain:

∞ 𝑖𝑖

𝑐𝑐𝑡𝑡 − 𝜔𝜔𝑎𝑎𝑡𝑡 − (1 − 𝜔𝜔)ℎ𝑡𝑡 = 𝐸𝐸𝑡𝑡 Σ𝑖𝑖=1 𝜌𝜌𝑤𝑤 {�𝜔𝜔𝑟𝑟𝑎𝑎,𝑡𝑡+𝑖𝑖 + (1 − 𝜔𝜔)𝑟𝑟ℎ,𝑡𝑡+𝑖𝑖 � − ∆𝑐𝑐𝑡𝑡+𝑖𝑖 }

This equation still contains the unobservable variable ℎ𝑡𝑡 on the left-hand side. To remove it,

we substitute our formulation linking the log of labor income to human capital, ℎ𝑡𝑡 = 𝜅𝜅 +

𝑦𝑦𝑡𝑡 + 𝑧𝑧𝑡𝑡 , into the above equation, which yields an approximate equation describing the log

consumption-aggregate wealth ratio using only observable variables on the left-hand side:

2018, Kyungsun Kim

∞ 𝑖𝑖 ��𝜔𝜔𝑟𝑟

𝑐𝑐𝑡𝑡 − 𝜔𝜔𝑎𝑎𝑡𝑡 − (1 − 𝜔𝜔)𝑦𝑦𝑡𝑡 = 𝐸𝐸𝑡𝑡 Σ𝑖𝑖=1 𝜌𝜌𝑤𝑤 𝑎𝑎,𝑡𝑡+𝑖𝑖 + (1 − 𝜔𝜔 )𝑟𝑟ℎ,𝑡𝑡+𝑖𝑖 � − ∆𝑐𝑐𝑡𝑡+𝑖𝑖 � + (1 − 𝜔𝜔 )𝑧𝑧𝑡𝑡

An important task in using 𝑐𝑐𝑐𝑐𝑦𝑦𝑡𝑡 to forecast asset returns is the estimation of the

parameters of the shared trend in consumption, labor income, and wealth. However, it may

appear that obtaining a consistent estimate of these parameters would be difficult because 𝑐𝑐𝑡𝑡 ,

𝑎𝑎𝑡𝑡 , and 𝑦𝑦𝑡𝑡 are endogenously determined. Thus we apply the asymptotic properties of

cointegrated variables, and we follow Stock and Watson (1993) and use a dynamic least

squares (DLS) technique that specifies a single equation taking the form

𝑘𝑘 𝑘𝑘

𝑐𝑐𝑛𝑛,𝑡𝑡 = 𝛼𝛼 + 𝛽𝛽𝑎𝑎 𝑎𝑎𝑡𝑡 + 𝛽𝛽𝑦𝑦 𝑦𝑦𝑡𝑡 + Σ𝑖𝑖=−𝑘𝑘 𝑏𝑏𝑎𝑎,𝑖𝑖 ∆𝑎𝑎𝑡𝑡−𝑖𝑖 + Σ𝑖𝑖=−𝑘𝑘 𝑏𝑏𝑦𝑦,𝑖𝑖 ∆𝑦𝑦𝑡𝑡−𝑖𝑖 + ϵt

� 𝑡𝑡 has significant forecasting power for future excess

returns. Row 3 reports long-horizon regressions using the dividend yield as the sole

forecasting variable.

At short and intermediate horizons, 𝑐𝑐𝑐𝑐𝑐𝑐

� 𝑡𝑡 continues to have the most forecasting power;

the predictive power for RREL is also concentrated at short horizons, and d-p and d-e are

significant only at very long horizons.

2018, Kyungsun Kim

However, at least consumption-wealth ratio seems to work well!

✓ Rangvid (2006)

He shows that the ratio of share prices to GDP tracks a large fraction of the variation over

time in expected returns on the aggregate stock market, capturing more of that variation than

do price–earnings and price–dividend ratios. The price–output ratio tracks long-term U.S.

cumulative stock returns almost as well as the cay-ratio of Lettau and Ludvigson (2001a),

although the cay-ratio tracks variation in U.S. excess returns better. The price–output ratio,

however, involves no parameter estimation and is easily constructed for non-U.S. countries.

We assume nonstationary behavior of dividends, 𝑑𝑑𝑡𝑡 = 𝑦𝑦𝑡𝑡 + 𝑣𝑣𝑡𝑡 , with 𝑦𝑦𝑡𝑡 as output and 𝑣𝑣𝑡𝑡

as a mean zero stationary disturbance term. If the nonstationary part of dividends arises from

output, we can write the “dynamic Gordon model” developed by Campbell and Shiller (1988)

as

∞ 𝑘𝑘

𝑝𝑝𝑡𝑡 − 𝑦𝑦𝑡𝑡 = E𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 �∆𝑦𝑦𝑡𝑡+1+𝑗𝑗 − 𝑟𝑟𝑡𝑡+1+𝑗𝑗 � + + 𝑣𝑣𝑡𝑡

1 − 𝜌𝜌

When prices are high for a given level of output, investors are willing to pay much for stocks

either because they expect the economy to perform well in terms of how much is produced or

because they expect future required rates of return to be low. It should also be noted that

variations in the price-output ratio reflect changes in expectations about returns over the next

many periods.

They demonstrate that a prime business cycle indicator, namely the output gap, predicts

stock and bond market returns both in-sample and out-of-sample. Thus, we provide a direct

line linking return predictability to economic fundamentals.

They find that the output gap, as measured by the deviations of the log of industrial

production from a trend that incorporates both a linear and a quadratic component, predicts

stock returns at business cycle frequencies. Unlike the work of Goyal and Welch (2006), in-

sample results of Cooper and Priestly (2009) relate a direct macroeconomic, business cycle

variable to expected returns and show that this relationship is statistically and economically

significant across time, countries, and types of financial asset.

Consider the following equation to measure the output gap:

𝑦𝑦𝑡𝑡 = 𝑎𝑎 + 𝑏𝑏 ∙ 𝑡𝑡 + 𝑐𝑐 ∙ 𝑡𝑡 2 + 𝑣𝑣𝑡𝑡

where 𝑦𝑦𝑡𝑡 is the log of industrial production, t is a time trend, and 𝑣𝑣𝑡𝑡 is an error term, which

is the output gap. Alternatively, we can subtract potential GDP from actual GDP to obtain the

measure of gap.

2018, Kyungsun Kim

By plotting the monthly measure of the output gap based on the quadratic trend along with

shaded NBER recessions dates, there appears to be a clear relationship between the output

gap and the business cycles.

We estimate the following univariate regression:

where 𝑟𝑟𝑡𝑡 is the excess return, gap is measured using a linear and a quadratic trend, and 𝑒𝑒𝑡𝑡 is

an error term.

Panel A shows that for one-month excess returns, the estimated coefficients on gap are

negative, implying that a fall in gap today predicts higher future expected returns. The

estimated coefficients are highly statistically significant and the 𝑅𝑅2 s from the one-month

excess return regressions are 2% for both indices. When predicting actual returns, results are

very similar to those of excess returns.

2018, Kyungsun Kim

The economic impact of gap on returns is large but reasonable; for example, the estimated

coefficient on gap from the annual predictability regression for the CRSP value-weighted

index is –0.925, implying that a one-standard-deviation fall in gap leads to an increase in

expected annual excess stock returns of 5.01%. This magnitude is larger than that of the

dividend yield (3.60% per annum) but smaller than cay (7.39% per annum) and the net

payout ratio (10.2%).

In summary, at business cycle frequencies, we find that actual and excess stock returns are

predictable using gap. This in-sample predictability is strong both statistically and

economically and provides evidence that stock returns vary with business cycle conditions:

expected returns rise as economic conditions worsen and fall when economic conditions

improve. Importantly, gap does not include any price variables. Therefore, we provide

independent evidence lending support to the notion that predictability is not due to behavioral

biases that could lead to a fall in prices, but rather is due to time variation in the required

compensation for risk.

They show that macroeconomic growth at the end of the year (fourth quarter or December)

strongly influences expected returns on risky financial assets, whereas economic growth

during the rest of the year does not. They also show that movements in the surplus

consumption ratio of Campbell and Cochrane (1999), a theoretically well-founded measure of

time-varying risk aversion linked to macroeconomic growth, influence expected returns

stronger during the fourth quarter than the other quarters of the year.

They regress US one-year-ahead excess stock returns on the quarterly growth rates of the

different macroeconomic variables in-sample, i.e., the results from the annual regression

𝑒𝑒

𝑅𝑅𝑡𝑡+1 = 𝛼𝛼 + 𝛽𝛽𝐺𝐺𝑡𝑡𝑖𝑖 + 𝜀𝜀𝑡𝑡+1

𝑒𝑒

where 𝑅𝑅𝑡𝑡+1 is the one-year-ahead excess stock returns and 𝐺𝐺𝑡𝑡𝑖𝑖 is the quarter i growth rate

of one of the business cycle variables.

2018, Kyungsun Kim

The results show that all fourth-quarter economic growth rates are strongly significant.

Likewise, the 𝑅𝑅�2 ’s from using the fourth-quarter economic growth rates are high, too. The

estimated sign on G4 is negative, as expected, such that a negative(positive) movement in

economic growth during the fourth quarter raises (lowers) expected returns. However,

economic growth during the other quarters does not significantly affect expected returns.

Jagannathan and Wang (2007) argue that investors compare consumption at the end of the

year with consumption at the end of last year, i.e., annual consumption growth; investors are

lazy possibly because of information and transaction costs, and thus, expected returns are

relatively more affected by end-of-the-year economic activity.

𝑟𝑟𝑡𝑡 = 𝑋𝑋𝑡𝑡 (𝜙𝜙 𝑇𝑇 ) �𝛽𝛽𝐸𝐸𝐸𝐸 + 𝛽𝛽𝑁𝑁𝑐𝑐𝑐𝑐 + 𝛽𝛽−𝑁𝑁𝑟𝑟 � + (𝜀𝜀𝐸𝐸𝐸𝐸,𝑡𝑡 + 𝜀𝜀𝑁𝑁𝑐𝑐𝑐𝑐,𝑡𝑡 + 𝜀𝜀𝑁𝑁𝑟𝑟 ,𝑡𝑡 )

The correlation between cash-flow proxies and stock returns may arise from association of

2018, Kyungsun Kim

cash-flow proxies with one-period expected returns, cash-flow news, and/or expected-return

news. 따라서, gdp gap 넣고 quarterly로 볼 때 DR도 추가적으로 고려해야하는 것이

아니냐 하는 critique이 있을 수 있음.

2018, Kyungsun Kim

[L2-1]

✓ Greenwood and Shleifer (2014)

Expected returns and expectation of returns

Measuring Investor expectations: mix of qualitative and quantitative measures.

• Gallup 1996-2011

Additionally, the survey provides (1) a proxy for expectations: an estimate of the percentage

return they expect on the market over the next twelve months, and (2) required returns: the

minimum acceptable rate of return

These two series are 84% correlated in levels and 65% correlated in one-month changes,

indicating that the qualitative measure of investor beliefs about market returns is capturing

the same variation as the quantitative measure.

• Graham-Harvey 2000-2011

The survey solicits CFO views regarding the U.S. economy and the performance of their

firms, as well as their expectations of returns on the U.S. stock market over the next twelve

months.

The survey measures the percentage of individual investors who are bullish, neutral, or

bearish on the stock market for the next six months.

The survey provides the classification of each newsletter as having “bullish,” “bearish,” or

“neutral” and forecasts of returns on the stock market over the near term. Their measure can

be summarized as the difference between the percentage of newsletters that are “bullish” and

the percentage that are “bearish.”

2018, Kyungsun Kim

They release surveys of individual investor confidence in the stock market. Greenwood and

Shleifer (2014) use the one-year individual confidence index, measured as the percentage of

individual investors who expect the market to rise over the following year.

Respondents are asked about their beliefs regarding annualized expected returns over the next

two to three years.

The high degree of correlation between the different survey measures suggests that we can

potentially isolate a common factor driving expectations across surveys. Using the three

series with the most time-series overlap (Gallup, II, and AA), we construct an investor

expectations index using the first principal component of the three series.

where R denotes the past k-period cumulative raw return on the stock market, P/D denotes the

price-dividend ratio and Z denotes other variables.

2018, Kyungsun Kim

The results show that when recent past returns are high, investors expect higher returns going

forward, and even after controlling for recent returns, investor expectations of future returns

are positively correlated with the price dividend ratio.

In panel B, only in the case of earnings growth do any of these variables consistently play

any role in explaining investor return expectations. When we include the price level and the

past stock market return, these variables again become insignificant.

(1) D/P

𝑘𝑘 𝑘𝑘

𝑣𝑣𝑣𝑣𝑣𝑣(𝑑𝑑𝑝𝑝𝑡𝑡 ) ≈ 𝑐𝑐𝑐𝑐𝑐𝑐�𝑑𝑑𝑝𝑝𝑡𝑡 , Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗−1 𝑟𝑟𝑡𝑡+𝑗𝑗 � − 𝑐𝑐𝑐𝑐𝑐𝑐�𝑑𝑑𝑝𝑝𝑡𝑡 , Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗−1 ∆𝑑𝑑𝑡𝑡+𝑗𝑗 � − 𝜌𝜌 𝑘𝑘 𝑐𝑐𝑐𝑐𝑐𝑐(𝑑𝑑𝑝𝑝𝑡𝑡 , 𝑑𝑑𝑝𝑝𝑡𝑡+𝑘𝑘 )

returns in the equation must be the same as time-series variation in expectations of returns;

Variation in dividend price ratios are driven not by expected dividend growth, but by

changing expected returns.

To explain variation in the expected returns implied by changes in the dividend price ratio,

researchers have put forth rational expectations models in which investors’ required market

returns fluctuate enough to match the data. These models come in three broad flavors: (1)

habit formation models in the spirit of Campbell and Cochrane (1999) that focus on the

variation in investor risk aversion, (2) long-run risk models in the spirit of Bansal and Yaron

(2004) in which investors’ perception of the quantity of long-run risk drives variation in

discount rates, and (3) so-called rare disaster models that capture time-varying estimates of

disaster probability (Barro 2006; Berkman, Jacobsen, and Lee 2011; Wachter 2013).

(2) cay

Under rational expectations, if ER vary predictably, then households with wealth invested

in the stock market will adjust their consumption accordingly. When consumption is high

2018, Kyungsun Kim

As suggested by the regressions in Table 2, Gallup expectations are even more strongly

negatively correlated with twelve-month changes in Log(D/P).

Gallup, Graham-Harvey, and Michigan expectations are uncorrelated with cay. Shiller

expectations are positively correlated with cay, whereas American Institute and Investors’

Intelligence expectations are negatively correlated with cay.

Forecasting regressions

𝑥𝑥

𝑅𝑅𝑡𝑡+𝑘𝑘 = 𝑎𝑎 + 𝑏𝑏𝑋𝑋𝑡𝑡 + 𝑢𝑢𝑡𝑡+𝑘𝑘

𝑥𝑥

where 𝑅𝑅𝑡𝑡+𝑘𝑘 denotes the k-month excess return, and X is a predictor variable.

Null hypothesis: if reported expectations measure true expected returns and are measured in

the same units as ER, then expectations should forecast future returns with a coefficient of

one. That is, if 𝑋𝑋𝑡𝑡 = E𝑡𝑡 [𝑅𝑅𝑡𝑡+𝑘𝑘 ] under the null hypothesis of rational expectations, the

coefficient a in the above equation is 0 and 𝑏𝑏 = 1.

2018, Kyungsun Kim

Panel A shows that Gallup survey return expectations negatively forecast future stock returns.

This is in

contrast to the dividend yield (Column (8)) and other measures of ERs, which are positively

related to subsequent returns over the sample period.

In all of the univariate specifications, the explanatory power is weak. Although the t-

statistics are low, we are interested in the null hypothesis that the coefficient on expectations

of returns is equal to one. We can reject this null with confidence for five of the seven

measures of expectations.

In Columns (12), (13), (14), and (15), we estimate analogous bivariate regressions using

the cay and surplus consumption predictors of excess returns. In these regressions,

expectations variables tend to reduce the ability of ERs to forecast future returns, even though

expectations are not by themselves especially good predictors of returns.

Expectations tend to negatively forecast returns, with part of the forecasting ability being

2018, Kyungsun Kim

driven by the negative correlation between expectations and our ERs measures.

Main findings

Expectation of returns (1) are highly correlated across survey series, (2) are extrapolative on

past realized return rather than fundamentals, (3) are negatively correlated with model-based

expected returns (D/P, cay), and (4) negatively forecasts future return over long-horizon.

Finding (3) invalidates time-varying risk aversion explanation in that high D/P is related to low

expectation of returns rather than high expected return. Together with winner-loser reversal, (3)

supports the negative correlation between analyst forecast and future performance reported by

La Porta (1996).

Table 7 shows the corresponding specifications for the full set of surveys, where we regress

the number of IPOs in month t on survey expectations in the same month. For all but one of

the series (Shiller), there is a positive correlation between equity issuance and investor

expectations. This evidence points in the direction of a model with at least two types of

market participants: extrapolative investors, whose expectations we have measured in this

paper, and perhaps more rational investors, some of whom are firms issuing their own equity,

who trade against them.

Interpretation

(1) Surveys are not noisy – they actually capture expectations of many investor, (2) data rules

out representative agent-based models of time-varying required returns.

⇒ Behavioral alternatives have been proposed.

(1) We rule out rational expectations models in which changes in market valuations are

driven by the required returns of a representative investor.

(2) Investors misperceive the future cash flows or cash flow growth. These models, however,

do not naturally predict extrapolative expectations of returns because market prices adjust to

whatever expectations about fundamentals investors hold.

(3) Fundamentals extrapolation; one class of investors extrapolates fundamentals, and another

group of investors

accommodates this demand. For example, following a positive shock to fundamentals,

extrapolators perceive continued high fundamental growth going forward and purchase the

risky asset from sophisticated rational traders. If both sophisticates and extrapolators are risk

2018, Kyungsun Kim

averse, the price rises, but from the perspective of the extrapolators, expectations of future

returns are high, consistent with the survey evidence.

2018, Kyungsun Kim

[L2-2]

✓ Ball, Kothari and Nikolaev (2013)

𝑅𝑅𝑡𝑡 =total unexpected security return;

𝑥𝑥𝑡𝑡 =portion of the total unexpected return 𝑅𝑅𝑡𝑡 that invariably is contemporaneously

captured in accounting income, 𝐼𝐼𝑡𝑡 ;

𝑦𝑦𝑡𝑡 =portion of total unexpected return 𝑅𝑅𝑡𝑡 that is not contemporaneously captured in 𝐼𝐼𝑡𝑡

unless required by conservative accounting;

𝑔𝑔𝑡𝑡 =portion of the total unexpected return 𝑅𝑅𝑡𝑡 that never is contemporaneously captured in

𝐼𝐼𝑡𝑡 , but always is incorporated with a lag;

𝐼𝐼𝑡𝑡 =accounting income;

𝑤𝑤𝑡𝑡 =an indicator variable that takes the value of one when conservative accounting rules

and practices lead to recognition of y in the current period; and

𝜀𝜀𝑡𝑡 = “noise” in accounting earnings that reverses in the next period.

𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐(𝑥𝑥𝑡𝑡 , 𝑦𝑦𝑡𝑡 ) = 𝜌𝜌𝑥𝑥𝑥𝑥 > 0, 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐(𝑥𝑥𝑡𝑡 , 𝑔𝑔𝑡𝑡 ) = 𝜌𝜌𝑥𝑥𝑥𝑥 > 0, and 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐(𝑦𝑦𝑡𝑡 , 𝑔𝑔𝑡𝑡 ) = 𝜌𝜌𝑦𝑦𝑦𝑦 > 0

The Basu (1997) asymmetric timeliness coefficient is estimated from the regression model:

𝐼𝐼𝑡𝑡 = 𝛼𝛼1 + 𝛼𝛼2 𝐷𝐷𝑡𝑡 + 𝛽𝛽1 𝑅𝑅𝑡𝑡 + 𝛽𝛽2 𝐷𝐷𝑡𝑡 𝑅𝑅𝑡𝑡 + 𝜀𝜀𝑡𝑡

where 𝐷𝐷𝑡𝑡 = 0 if 𝑅𝑅𝑡𝑡 ≥ 0, 𝐷𝐷𝑡𝑡 = 1 if 𝑅𝑅𝑡𝑡 < 0, and 𝛽𝛽2 is the asymmetric timeliness

coefficient. 𝛽𝛽2 then is the incremental coefficient on negative return (the proxy for negative

economic income), and is predicted to be positive because conditionally conservative

accounting incorporates negative economic income into accounting income sooner than it

incorporates positive economic income.

Let 𝛽𝛽̂2 denote the OLS estimate of 𝛽𝛽2 ,

where 𝛾𝛾1 = and 𝛾𝛾2 =

𝑣𝑣𝑣𝑣𝑣𝑣(𝑅𝑅𝑡𝑡 |𝑅𝑅𝑡𝑡 ≥0) 𝑣𝑣𝑣𝑣𝑣𝑣(𝑅𝑅𝑡𝑡 |𝑅𝑅𝑡𝑡 <0)

We conclude that the Basu asymmetric timeliness coefficient 𝛽𝛽̂2 is positive in the presence

of conditional conservatism, and zero in the absence of conditional conservatism, consistent

with it being a valid estimator.

2018, Kyungsun Kim

Recall Voulteenaho (2002).

The Vuolteenaho return decomposition model

∞ ∞

𝑟𝑟𝑡𝑡 − 𝐸𝐸𝑡𝑡−1 (𝑟𝑟𝑡𝑡 ) = ∆𝐸𝐸𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑟𝑟𝑒𝑒𝑡𝑡+𝑗𝑗 − 𝑖𝑖𝑡𝑡+𝑗𝑗 � − ∆𝐸𝐸𝑡𝑡 Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑟𝑟𝑡𝑡+𝑗𝑗

where 𝑟𝑟𝑡𝑡 = log equity return (cum dividend) in excess of the risk free rate in period t; 𝜌𝜌 is a

constant discount rate term; 𝑖𝑖𝑡𝑡 = log of one plus the risk free rate in period t; 𝑟𝑟𝑜𝑜𝑒𝑒𝑡𝑡 = log of

one plus return on equity (that is, earnings divided by beginning of period book value of

equity) in period t.

Defining the unexpected stock return components as expected-return news(Nr) and

earnings news (Ne):

where

∞

𝑁𝑁𝑁𝑁 = ∆𝐸𝐸𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 (𝑟𝑟𝑟𝑟𝑒𝑒𝑡𝑡+𝑗𝑗 − 𝑖𝑖𝑡𝑡+𝑗𝑗 )=earnings news

∞

𝑁𝑁𝑁𝑁 = ∆𝐸𝐸𝑡𝑡 Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑟𝑟𝑡𝑡+𝑗𝑗 =discount rate news

Define 𝑧𝑧𝑖𝑖,𝑡𝑡 to be a vector of firm-specific state variables that follows AR(1):

We estimate a parsimonious VAR with three state variables consisting of log stock returns

(𝑟𝑟𝑡𝑡 ), log of one plus ROE (earnings scaled by book value of equity), and the log book-to-

market ratio (𝑏𝑏𝑏𝑏𝑡𝑡 ). The VAR model can then be described as a system of (mean-adjusted)

equations:

Which implies:

2018, Kyungsun Kim

∞ ∞ ∞

𝑁𝑁𝑟𝑟𝑡𝑡 = ∆𝐸𝐸𝑡𝑡 Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑟𝑟𝑡𝑡+𝑗𝑗 = 𝐸𝐸𝑡𝑡 Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑟𝑟𝑡𝑡+𝑗𝑗 − 𝐸𝐸𝑡𝑡−1 Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑟𝑟𝑡𝑡+𝑗𝑗

= 𝑒𝑒1′ 𝜌𝜌𝜌𝜌(𝐼𝐼 − 𝜌𝜌𝜌𝜌)−1 𝜂𝜂𝑖𝑖,𝑡𝑡

∞ ∞ ∞

𝑁𝑁𝑒𝑒𝑡𝑡 = ∆𝐸𝐸𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑟𝑟𝑒𝑒𝑡𝑡+𝑗𝑗 − 𝑖𝑖𝑡𝑡 � = 𝐸𝐸𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 �𝑟𝑟𝑟𝑟𝑒𝑒𝑡𝑡+𝑗𝑗 − 𝑖𝑖𝑡𝑡 � − 𝐸𝐸𝑡𝑡−1 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 (𝑟𝑟𝑟𝑟𝑒𝑒𝑡𝑡+𝑗𝑗 − 𝑖𝑖𝑡𝑡 )

= 𝑒𝑒2′ (𝐼𝐼 − 𝜌𝜌𝜌𝜌)−1 𝜂𝜂𝑖𝑖,𝑡𝑡

The conservatism ratio is defined as ratio of unexpected current earnings to total earnings

news. The ratio measures how much of the total earnings shock is incorporated into current

period unexpected earnings.

Perhaps the simplest example is to assume that the firm’s earnings, as measured by 𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡 ,

follow a stationary AR(1) process with drift and that the firm’s expected rate of return (cost

of capital) is intertemporally constant so that:

where 𝛽𝛽 is the persistence parameter assumed to lie between 0 and 1, and 𝜀𝜀𝑡𝑡 ~(0, 𝜎𝜎 2 ) is a

zero-mean error term. It is fairly straightforward to show that in this case 𝐶𝐶𝑅𝑅𝑡𝑡 ≈ 1 − 𝛽𝛽. In

other words, the conservatism ratio (approximately) equals one minus the persistence of 𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡

so that the more persistent are earnings, the less of the total earnings shock recognized in

current earnings relative to future earnings.

We measure the conservatism ratio CR (at the firm year level) as the current period

earnings shock (CES) divided by earnings news (Ne). Therefore, CR shows the proportion of

the total shock to current and expected future earnings recognized in current year earnings.

We investigate the empirical properties of CR by examining its association with good and

bad news using both univariate and multivariate analyses. Consistent with the conservative

nature of accounting, we expect CR to be negatively associated with unexpected returns (a

proxy for news) and to be more highly negatively associated with bad news events than with

good news events.

2018, Kyungsun Kim

As expected, the coefficient on the revisions to returns is negative and significant, and the

coefficient on the interaction variable is positive and significant. Specifically, the coefficient

on the revisions to returns is -0.372, and the coefficient on the interaction variable is 0.863.

Hence, the coefficient on negative news equals 0.491. This indicates that CR is positively

(negatively) associated with bad (good) news, consistent with the conservative nature of

financial accounting.

A negative CR raises interpretation issues. Specifically, the cases where earnings news is

negative and the current period earnings shock (CES) is positive may represent overly

aggressive financial reporting because the firm has a positive CES even though it will

experience an overall negative shock to expected current and future cash flows. Similarly, cases

where earnings news is positive and CES is negative may represent overly conservative

financial reporting.

2018, Kyungsun Kim

The returns of stocks are partially driven by changes in their expected cash-flow. Using

revisions in analyst earnings forecasts, we construct an analyst earnings beta that measures the

covariance between the cash-flow innovations of an asset and those of the market. A higher

analyst earnings beta implies greater sensitivity to market-wide revisions in expected cash-flow,

and therefore higher systematic risk. Our analyst earnings beta captures exposure to

macroeconomic fluctuations and has a positive risk premium that provides a partial explanation

for the value premium, size premium, and long-term return reversals.

Campbell and Shiller (1988) decompose stock returns into a cash-flow component (𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+1)

and a discount rate component (𝑁𝑁𝐷𝐷𝐷𝐷,𝑡𝑡+1 ).

∞

𝑁𝑁𝐷𝐷𝐷𝐷,𝑡𝑡+1 = (𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 )Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑟𝑟𝑡𝑡+𝑗𝑗+1

∞

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+1 = (𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 )Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 ∆𝑑𝑑𝑡𝑡+𝑗𝑗+1

where 𝐵𝐵𝑡𝑡+1 , 𝑋𝑋𝑡𝑡+1 , and 𝐷𝐷𝑡𝑡+1 denote a firm’s book value, earnings, and cash-flow,

respectively, with 𝑑𝑑𝑡𝑡+𝑗𝑗+1 being the log of 𝐷𝐷𝑡𝑡+𝑗𝑗+1 . The log return on book equity (roe) is

defined as

𝑋𝑋𝑡𝑡+𝑗𝑗+1

𝑒𝑒𝑡𝑡+𝑗𝑗+1 = log(1 + )

𝐵𝐵𝑡𝑡+𝑗𝑗

Voulteenaho (2002) log-linearizes the clean-surplus identity to replace the ∆𝑑𝑑𝑡𝑡+𝑗𝑗+1 with log

return on book equity, which implies the cash-flow component becomes

∞

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+1 = (𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 )Σ𝑗𝑗=1 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝑗𝑗+1

This implies that cash-flow innovations and earnings revisions contain similar information

when evaluated over an infinite horizon.

Data description

Firm-month observations include a firm’s earnings in the previous year (𝐴𝐴0𝑡𝑡 ), consensus

earnings forecasts for the current and subsequent fiscal year (𝐴𝐴1𝑡𝑡 , 𝐴𝐴2𝑡𝑡 ), along with its long-

term growth forecast (𝐿𝐿𝐿𝐿𝐺𝐺𝑡𝑡 ). The long-term growth forecast represents an annualized

percentage growth rate.

2018, Kyungsun Kim

Let 𝑋𝑋𝑡𝑡,𝑡𝑡+𝑗𝑗 denote the expectation of 𝑋𝑋𝑡𝑡+𝑗𝑗 , with the additional subscript referring to an

expectation at time t. In the first stage, expected earnings are computed directly from analyst

forecasts until year 5 as follows:

𝑋𝑋𝑡𝑡,𝑡𝑡+1 = 𝐴𝐴1𝑡𝑡

𝑋𝑋𝑡𝑡,𝑡𝑡+2 = 𝐴𝐴2𝑡𝑡

Given that 𝐿𝐿𝐿𝐿𝐺𝐺𝑡𝑡 exceeds 30% for certain portfolios, it is unrealistic to assume that such

high earnings growth will continue indefinitely. Therefore, we assume that expected earnings

growth converges (linearly) to an economy-wide steady-state growth rate 𝑔𝑔𝑡𝑡 from year 6 to

10 in the second stage. Specifically, expected earnings are estimated as

𝑗𝑗 − 4

𝑋𝑋𝑡𝑡,𝑡𝑡+𝑗𝑗+1 = 𝑋𝑋𝑡𝑡,𝑡𝑡+𝑗𝑗 [1 + 𝐿𝐿𝐿𝐿𝐺𝐺𝑡𝑡 + (𝑔𝑔𝑡𝑡 − 𝐿𝐿𝐿𝐿𝐺𝐺𝑡𝑡 )]

5

for 𝑗𝑗 = 5, … , 9. The steady-state growth rate 𝑔𝑔𝑡𝑡 is computed as the cross-sectional average of

𝐿𝐿𝐿𝐿𝐺𝐺𝑡𝑡 . We also assume the cash-flow payout is equal to a fixed portion (𝜓𝜓) of the ending-period

book value. Under this assumption, the evolution of expected book value is 𝐵𝐵𝑡𝑡,𝑡𝑡+𝑗𝑗+1 =

(𝐵𝐵𝑡𝑡,𝑡𝑡+𝑗𝑗 + 𝑋𝑋𝑡𝑡,𝑡𝑡+𝑗𝑗+1 )/(1 − 𝜓𝜓). In the third stage, expected earnings growth converges to 𝑔𝑔𝑡𝑡 ,

which implies expected accounting returns converge to 𝑔𝑔𝑡𝑡 /(1 − 𝜓𝜓) beyond year 10.

In summary, the expected log accounting return 𝑒𝑒𝑡𝑡,𝑡𝑡+𝑗𝑗 is estimated at time t as

⎪ 𝐵𝐵 𝑡𝑡,𝑡𝑡+𝑗𝑗

𝑒𝑒𝑡𝑡,𝑡𝑡+𝑗𝑗 =

⎨ 𝑔𝑔𝑡𝑡

⎪ log �1 + � 𝑓𝑓𝑓𝑓𝑓𝑓 𝑗𝑗 ≥ 10,

⎩ 1 − 𝜓𝜓

∞ 9 𝜌𝜌10 𝑔𝑔𝑡𝑡

𝐸𝐸𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝑗𝑗+1 = Σj=0 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡,𝑡𝑡+𝑗𝑗+1 + log(1 + )

1 − 𝜌𝜌 1 − 𝜓𝜓

∞ ∞

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 = 𝐸𝐸𝑡𝑡+𝛿𝛿 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝑗𝑗+1 − 𝐸𝐸𝑡𝑡 Σ𝑗𝑗=0 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝑗𝑗+1

2018, Kyungsun Kim

Although earnings forecasts pertain to annual intervals, their revisions are computed over

monthly horizon (𝛿𝛿).

Once the cash-flow component 𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 is defined, earnings betas are estimated using the

following regression:

𝑖𝑖 𝑖𝑖 𝑖𝑖 𝑀𝑀 𝑖𝑖

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 = 𝛼𝛼𝐶𝐶𝐶𝐶 + 𝛽𝛽𝐶𝐶𝐶𝐶 𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 + 𝜀𝜀𝑡𝑡+𝛿𝛿

where the i and M superscripts denote portfolio i and the market, respectively. The earnings

beta 𝛽𝛽𝐶𝐶𝐶𝐶 measures the covariance between changes in the expected cash-flow of a portfolio

𝑖𝑖

and these changes for the market. A higher 𝛽𝛽𝐶𝐶𝐶𝐶 implies that portfolio i has a greater sensitivity

to fluctuations in the market’s expected cash-flows, hence greater systematic risk.

The decomposition is then utilized to estimate the contribution of revisions in expected

earnings within the first five years as well as the subsequent five-year horizon to the composite

earnings betas. We begin by decomposing the cash-flow innovations into three components:

𝑖𝑖,1 4 4

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 = Σj=0 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝛿𝛿,𝑡𝑡+𝑗𝑗+1 − Σj=0 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡,𝑡𝑡+𝑗𝑗+1

𝑖𝑖,2 9 9

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 = Σj=5 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝛿𝛿,𝑡𝑡+𝑗𝑗+1 − Σj=5 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡,𝑡𝑡+𝑗𝑗+1

𝑖𝑖,3 ∞ ∞

𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 = Σj=10 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡+𝛿𝛿,𝑡𝑡+𝑗𝑗+1 − Σj=10 𝜌𝜌 𝑗𝑗 𝑒𝑒𝑡𝑡,𝑡𝑡+𝑗𝑗+1

where 𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 = 𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 + 𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 + 𝑁𝑁𝐶𝐶𝐶𝐶,𝑡𝑡+𝛿𝛿 . Three corresponding earnings betas are then

defined as the respective covariances between these components and the cash-flow innovations

of the market. The sum of these earnings betas, 𝛽𝛽1𝑖𝑖 + 𝛽𝛽2𝑖𝑖 + 𝛽𝛽3𝑖𝑖 , equals the composite earnings

𝑖𝑖

beta 𝛽𝛽𝐶𝐶𝐶𝐶 .

2018, Kyungsun Kim

They also evaluate the stationarity of the monthly cash-flow innovations using the

Augmented Dickey-Fuller (ADF) test with a constant and one lag. With a critical value of -3.99

at the 1% confidence level, a unit root in the portfolio-level cash-flow innovations is

overwhelmingly rejected. Thus, they reject the presence of autocorrelation in the portfolio-

level cash-flow innovations. ⇒ CAPM is DEAD?!

The t-values are computed using the Newey-West formula with 12 lags to account for any

possible autocorrelation in the errors. Value stocks have significantly higher earnings beta

estimates than growth stocks, 1.12 versus 0.43, with this difference being highly significant (t-

value of 3.25). The difference across the earnings beta estimates of the size portfolio is also

significant, with the small stock portfolio having an earnings beta estimate of 1.14 in

comparison to 0.83 for the large stock portfolio. Furthermore, past long-term losers have an

earnings beta estimate of 1.20 while past long-term winners have a smaller earnings beta

estimate of 0.42.

2018, Kyungsun Kim

The CAPM

- Fact 1: Two assets which have the same covariance with the market must have the same

expected return.

- Fact 2: The risk premium of an asset, i.e., 𝐸𝐸 (𝑟𝑟�𝚤𝚤 ) − 𝑟𝑟𝑓𝑓 will depend linearly on the risk, i.e., its

covariance with the market portfolio.

- Jensen’s alpha:

𝛼𝛼𝑖𝑖 = �𝑟𝑟��������� ̂ ����������

𝚤𝚤 − 𝑟𝑟𝑓𝑓 − 𝛽𝛽𝑖𝑖 �𝑟𝑟 𝑀𝑀 − 𝑟𝑟𝑓𝑓

= 𝑟𝑟�𝚤𝚤 − (𝑟𝑟�𝑓𝑓 + 𝛽𝛽̂𝑖𝑖 �𝑟𝑟����������)

𝑀𝑀 − 𝑟𝑟𝑓𝑓

So if 𝛼𝛼 > 0,

- The security has earned a higher return on average than is required for its level of risk.

- Or the security might not be mispriced, but rather the CAPM is wrong.

2018, Kyungsun Kim

Factor Models

✓ Chen, Roll, and Ross (1986)

Table 1 shows the summary of variables.

Using the state variables defined in table 1 implies that individual stock returns follow a factor

model of the form

𝑅𝑅 = 𝑎𝑎 + 𝑏𝑏𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 + 𝑏𝑏𝐷𝐷𝐷𝐷𝐷𝐷 𝐷𝐷𝐷𝐷𝐷𝐷 + 𝑏𝑏𝑈𝑈𝑈𝑈 𝑈𝑈𝑈𝑈 + 𝑏𝑏𝑈𝑈𝑈𝑈𝑈𝑈 𝑈𝑈𝑈𝑈𝑈𝑈 + 𝑏𝑏𝑈𝑈𝑈𝑈𝑈𝑈 𝑈𝑈𝑈𝑈𝑈𝑈 + 𝑒𝑒

where the betas are the loadings on the state variables, a is the constant term, and e is an

idiosyncratic error term. The procedure was as follows.

(a) A sample of assets was chosen. (b) The assets' exposure to the economic state variables was

estimated by regressing their returns on the unanticipated changes in the economic variables

over some estimation period (we used the previous 5 years). (c) The resulting estimates of

exposure (betas) were used as the independent variables in 12 cross-sectional regressions, one

regression for each of the next 12 months, with asset returns for the month being the dependent

variable. Each coefficient from a cross-sectional regression provides an estimate of the sum of

the risk premium, if any, associated with the state variable and the unanticipated movement in

2018, Kyungsun Kim

the state variable for that month. (d) Steps b and c were then repeated for each year in the

sample, yielding for each macro variable a time series of estimates of its associated risk

premium. The time-series means of these estimates were then tested by a t-test for significant

difference from zero.

The following is the results in panel D in table 4.

The tests in table 4 are tests of whether the set of economic variables can be usefully augmented

by the inclusion of a market index. The numbers are 10 times of percent per month. For

(11.756)(12)

example, 10

= 14.1% is the annual risk premium on the MP factor (growth rate in

industrial production).

Results of table 4

- Growth in industrial production (MP): + risk premium

- Unexpected inflation (UI): - risk premium

- Unexpected changes in the difference between returns on corporate and government bonds

(UPR): + risk premium

- Unexpected changes in the difference between returns on long and short term government

bonds (UTS): - risk premium.

- Changes in expected inflation (DEI): insignificant

2018, Kyungsun Kim

Value strategies might produce higher returns because they are contrarian to "naive"

strategies followed by other investors. These naive strategies might range from extrapolating

past earnings growth too far into the future, to assuming a trend in stock prices, to overreacting

to good or bad news, or to simply equating a good investment with a well-run company

irrespective of price. Contrarian investors bet against such naive investors.

An alternative explanation of why value strategies have produced superior returns, argued

most forcefully by Fama and French (1992), is that they are fundamentally riskier.

The evidence in Table V is consistent with the extrapolation model. Glamour stocks have

historically grown fast in sales, earnings, and cash flow relative to value stocks. According to

most of our measures, the market expected the superior growth of glamour firms to continue

for many years. In the very short-run, the expectations of continued superior growth of glamour

stocks were on average born out. However, beyond the first couple years, growth rates of

glamour stocks and value stocks were essentially the same. The evidence suggests that forecasts

were tied to past growth rates and were too optimistic for glamour stocks relative to value

stocks.

2018, Kyungsun Kim

Value stocks would be fundamentally riskier than glamour stocks if, first, they underperform

glamour stocks in some states of the world, and second, those are on average "bad" states, in

which the marginal utility of wealth is high, making value stocks unattractive to risk-averse

investors.

2018, Kyungsun Kim

Figure 2 present the year-by-year performance of the value strategy relative to the glamour

strategy over the April 1968 to April 1990 period. The results show that value strategies have

consistently outperformed glamour strategies. Over any 5-year horizon in the sample, the value

strategy was a sure winner. Even for a one-year horizon, the downside of this strategy was

fairly low. To explain these numbers with a multifactor risk model would require that the

relatively few instances of underperformance of the value portfolio are tightly associated with

very bad states of the world as defined by some payoff relevant factor.

2018, Kyungsun Kim

Table VIII also presents average annual standard deviations of the various portfolio returns.

The results show that value portfolios have somewhat higher standard deviations of returns

than glamour portfolios. Because of its much higher mean return, the value strategy's higher

standard deviation does not translate into greater downside risk. Second, the higher standard

deviation of value stocks appears to be due largely to their smaller average size, since the

standard deviation of size-adjusted returns is virtually the same for value and glamour

portfolios.

⇒ Value minus growth strategy does not have high variance, high beta, nor high downside risk,

and it underperforms in bad state. So maybe it’s an inefficiency, driven again by overreaction.

✓ Shleifer (2000)

It is not entirely obvious from the Fama and French analysis how either size or the market to

book ratio, whose economic interpretations are rather dubious in the first place, have emerged

as heretofore unnoticed but ciritical indicators of fundamental risk, more important than the

market risk itself. Fama and French speculate that perhaps the size and market to book ratio

proxy for different aspects of the ‘distress risk’, but up to now there has been no direct evidence

in support this interpretation, and indeed Lakonishok et al. (1994) find no evidence of poor

performance of value strategies in extremely bad times. The fact that the small firm effect has

disappeared in the last 15 years, and before that was concentrated in January, also presents a

problem for the risk interpretation.

2018, Kyungsun Kim

From COMPUSTAT we construct a standard measure of profitability: net income relative

to total assets. Previous authors have measured total assets at book value, but we find better

explanatory power when we measure the equity component of total assets at market value by

adding the book value of liabilities to the market value of equities. We call this series

NIMTA (Net Income to Market-valued Total Assets) and the traditional series NITA (Net

Income to Total Assets). We also use COMPUSTAT to construct a measure of leverage:

total liabilities relative to total assets. We again find that a market-valued version of this

series, defined as total liabilities divided by the sum of market equity and book liabilities,

performs better than the traditional book-valued series. We call the two series TLMTA and

TLTA, respectively. To these standard measures of profitability and leverage, we add a

measure of liquidity, the ratio of a company’s cash and short-term assets to the market value

of its assets (CASHMTA). We also calculate each firm’s market-to-book ratio (MB).

We calculate the monthly log excess return on each firm’s equity relative to the S&P 500

index (EXRET), the standard deviation of each firm’s daily stock return over the past three

months (SIGMA), and the relative size of each firm measured as the log ratio of its market

capitalization to that of the S&P 500 index (RSIZE). We calculate each firm’s log price per

share, truncated above at $15 (PRICE). This captures a tendency for distressed firms to trade

at low prices per share, without reverse-splitting to bring price per share back into a more

normal range.

The average excess returns reported in the first row of Table 6 are strongly and almost

monotonically declining in failure risk. The average excess returns for the lowest-risk 5% of

stocks are positive at 3.4% per year, and the average excess returns for the highest-risk 1% of

stocks are significantly negative at -17.0% per year.

2018, Kyungsun Kim

The low-failure-risk portfolios have negative market betas for their excess returns (that is,

betas less than one for their raw returns), negative loadings on the value factor HML, and

negative loadings on the small firm factor SMB. The high-failure-risk portfolios have

positive market betas for their excess returns, positive loadings on HML, and extremely high

loadings on SMB, reflecting the role of market capitalization in predicting bankruptcies at

medium and long horizons.

A long-short portfolio that holds the safest decile of stocks and shorts the decile with the

highest failure risk has an average excess return of 10.0% with a t statistic of 1.9; it has a

CAPM alpha of 12.4% with a t statistic of 2.3; and it has a Fama-French three-factor alpha of

22.7% with a t statistic of 6.1.

Stocks with a high risk of failure are highly volatile, with average standard deviations of

almost 80% in the 5% most distressed stocks and 95% in the 1% most distressed stocks. This

volatility does not fully diversify at the portfolio level. The returns on distressed stocks are

also positively skewed, both at the portfolio level and particularly at the individual stock

level.

The wide spread in firm characteristics across the failure risk distribution suggests the

possibility that the apparent underperformance of distressed stocks results from their

characteristics rather than from financial distress per se.

From the magnitude of the regression coefficient, profitability is the most important

predictor of failure rate.

2018, Kyungsun Kim

(1) Perhaps the most obvious explanation is that stock market investors underreact to

negative information about company prospects. Hong, Lim, and Stein (2000) have argued

that corporate managers have incentives to withhold bad news, which therefore reaches the

market only gradually.

(2) Barberis and Huang (2004) model the behavior of investors whose preferences satisfy the

cumulative prospect theory of Tversky and Kahneman (1992). Such investors have a strong

desire to hold positively skewed portfolios, and may even hold undiversified positions in

positively skewed assets. It is striking that both individual distressed stocks and our portfolios

of distressed stocks also offer returns with strong positive skewness.

(3) Finally, the distress anomaly may result from the preferences of institutional investors,

together with a shift of assets from individuals to institutions during our sample period. If

institutions more generally prefer stocks with low failure risk, and tend to sell stocks that

enter financial distress, then a similar mechanism could drive our results.

Findings show that profitability decrease with default probability, partially supporting

explanation (1).

(1) Skewness

(𝑅𝑅 − 𝑅𝑅�)3

𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 � �

�3

𝜎𝜎

(2) Kurtosis

(𝑅𝑅 − 𝑅𝑅�)4

𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘𝑘 = 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 � �−3

�4

𝜎𝜎

They study the asset pricing implications of Tversky and Kahneman (1992) cumulative

prospect theory. Their main result is that a security’s own skewness can be priced: a positively

skewed security can be “overpriced” and can earn a negative average excess return.

Consider the gamble (𝑥𝑥, 𝑝𝑝; 𝑦𝑦, 𝑞𝑞) to be read as “gain x with probability p and y with

probability q, independent of other risks,” where 𝑥𝑥 ≤ 0 ≤ 𝑦𝑦 or 𝑦𝑦 ≤ 0 ≤ 𝑥𝑥, and where 𝑝𝑝 +

𝑞𝑞 = 1. In the expected utility framework, an agent with utility function 𝑢𝑢(∙) evaluates the risk

by computing

where W is his current wealth. In the original version of prospect theory, the agent assigns the

gamble the value

where 𝑣𝑣(∙) and 𝜋𝜋(∙) are known as the value function and the probability weighting function,

2018, Kyungsun Kim

respectively.

(𝑥𝑥−𝑚𝑚 , 𝑝𝑝−𝑚𝑚 ; … ; 𝑥𝑥−1 , 𝑝𝑝−1 ; 𝑥𝑥0 , 𝑝𝑝0 ; 𝑥𝑥1 , 𝑝𝑝1 ; … ; 𝑥𝑥𝑛𝑛 , 𝑝𝑝𝑛𝑛 )

where 𝑥𝑥𝑖𝑖 < 𝑥𝑥𝑗𝑗 for 𝑖𝑖 < 𝑗𝑗 and x0 = 0, by assigning is the value

𝑛𝑛

𝛴𝛴𝑖𝑖=−𝑚𝑚 𝜋𝜋𝑖𝑖 𝑣𝑣(𝑥𝑥𝑖𝑖 )

where

𝑤𝑤 + (𝑝𝑝𝑖𝑖 + ⋯ + 𝑝𝑝𝑛𝑛 ) − 𝑤𝑤 + (𝑝𝑝𝑖𝑖+1 + ⋯ + 𝑝𝑝𝑛𝑛 ) 0 ≤ 𝑖𝑖 ≤ 𝑛𝑛

𝜋𝜋𝑖𝑖 = � − 𝑓𝑓𝑓𝑓𝑓𝑓

𝑤𝑤 (𝑝𝑝−𝑚𝑚 + ⋯ + 𝑝𝑝𝑖𝑖 ) − 𝑤𝑤 − (𝑝𝑝−𝑚𝑚 + ⋯ + 𝑝𝑝𝑖𝑖−1 ) −𝑚𝑚 ≤ 𝑖𝑖 ≤ 0

and where 𝑤𝑤 + (∙) and 𝑤𝑤 −(∙) are the probability weighting functions for gains and losses,

respectively. Tversky and Kahneman (1992) propose the functional forms

𝑥𝑥 𝛼𝛼 𝑥𝑥 ≥ 0

𝑣𝑣 (𝑥𝑥 ) = � 𝑓𝑓𝑓𝑓𝑓𝑓

−𝜆𝜆(−𝑥𝑥 )𝛽𝛽 𝑥𝑥 < 0

and

𝑃𝑃𝛾𝛾 𝑃𝑃𝛿𝛿

𝑤𝑤 +(𝑃𝑃) = (𝑃𝑃𝛾𝛾+(1−𝑃𝑃)𝛾𝛾)1/𝛾𝛾, 𝑤𝑤 −(𝑃𝑃) = 1/𝛿𝛿

�𝑃𝑃𝛿𝛿 +(1−𝑃𝑃)𝛿𝛿 �

For 𝛼𝛼 ∈ (0,1), 𝛽𝛽 ∈ (0,1), and 𝜆𝜆 > 1, the value function 𝑣𝑣(∙) is concave over gains,

convex over losses, and exhibits a greater sensitivity to losses than to gains. The degree of

sensitivity to losses is determined by 𝜆𝜆, the coefficient of loss aversion. For 𝛾𝛾 ∈ (0,1) and

𝛿𝛿 ∈ (0,1), the weighting functions 𝑤𝑤 + (∙) and 𝑤𝑤 −(∙) captures the overweighting of low

probability: for low, positive P, 𝑤𝑤(𝑃𝑃) > 𝑃𝑃.

The above equation of 𝜋𝜋𝑖𝑖 shows that, under cumulative prospect theory, the weighting

function is applied to the cumulative probability distribution. The effect of applying the

2018, Kyungsun Kim

the tails of that distribution. The most extreme outcomes, 𝑥𝑥−𝑚𝑚 and 𝑥𝑥𝑛𝑛 are assigned the

probability weights 𝑤𝑤 −(𝑝𝑝−𝑚𝑚 ) and 𝑤𝑤 +(𝑝𝑝𝑛𝑛 ), respectively. If 𝑝𝑝−𝑚𝑚 and 𝑝𝑝𝑛𝑛 are small, we

then have 𝑤𝑤 −(𝑝𝑝−𝑚𝑚 ) > 𝑝𝑝−𝑚𝑚 and 𝑤𝑤 +(𝑝𝑝𝑛𝑛 ) > 𝑝𝑝𝑛𝑛 . The most extreme outcomes – the outcomes

in the tails – are therefore overweighted.

Barberis and Huang (2008) show that a heterogeneous holding equilibrium exists in which

investors with cumulative prospect theory utility functions are indifferent between holding

the market portfolio and an under-diversified portfolio in which the asset with jackpot returns

has a nontrivial weight. The asset with jackpot returns earns negative expected returns in this

equilibrium. However, for the equilibrium to exist, the payoffs of the jackpot asset must be

sufficiently skewed.

Main results

In such a financial market, investors pay very high prices for stocks that are lottery-like – in

other words, stocks that offer a small chance of a very large payoff. And since investors pay

very high prices for these stocks, they earn low returns, on average.

Historical data show that the long-run average return on IPO stocks is surprisingly low.

(Maybe, those stocks are overpriced at the time of IPO, and then corrected overtime.)

Intuitively, IPO stocks seem riskier than the average stock – after all, firms that do an IPO tend

to be young firms, firms whose prospects are still quite uncertain. Riskier stocks should earn

higher returns, on average, to compensate for their higher risk. In reality, however, it is low –

and that’s the puzzle.

Campbell, Hilscher, and Szilagyi (2008) show that firms with a high probability of default

have abnormally low average future returns. We show that firms with a high potential for

default (death) also tend to have a relatively high probability of extremely large (jackpot)

payoffs. Consistent with an investor preference for skewed, lottery-like payoffs, stocks with

high predicted probabilities for jackpot returns earn abnormally low average returns. Stocks

with high death or jackpot probability have relatively low institutional ownership and the

jackpot effect we find is much stronger in stocks with high limits to arbitrage.

Defining jackpots

We set a jackpot return as a log return greater than 100% over the next year. Thus, the

likelihood of a jackpot return is 𝑞𝑞 = 𝑝𝑝𝑝𝑝𝑝𝑝𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑜𝑜𝑜𝑜 𝐿𝐿𝐿𝐿𝐿𝐿�𝑅𝑅𝑖𝑖,𝑡𝑡 � > 1, where 𝑅𝑅𝑖𝑖,𝑡𝑡 is the gross

return of stock i, at time t, in the highest distress risk portfolio.

exp(𝑎𝑎 + 𝑏𝑏 × 𝑋𝑋𝑖𝑖,𝑡𝑡−1 )

𝑃𝑃𝑡𝑡−1 �𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝑡𝑡𝑖𝑖,𝑡𝑡,𝑡𝑡+12 = 1� =

1 + exp(𝑎𝑎 + 𝑏𝑏 × 𝑋𝑋𝑖𝑖,𝑡𝑡−1 )

2018, Kyungsun Kim

where 𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝑡𝑡𝑖𝑖,𝑡𝑡,𝑡𝑡+12 is a dummy variable that equals one if the firm’s log return in the next

12-month period is larger than 100% and 𝑋𝑋𝑖𝑖,𝑡𝑡−1 is a vector of independent variables known at

t-1.

We use variables employed by prior skewness research to predict jackpot returns: the stock’s

(log) return over the last 12 months (RET12), volatility (STDEV) and skewness (SKEW) of

daily log returns over the past three months, detrended stock turnover.

Among all the variables, AGE, STDEV, and SIZE has the largest impact on the odds ratio of

the logistic regression.

2018, Kyungsun Kim

In table 4, we report the results from tests on value-weighted decile portfolios formed from

sorts on out-of-sample predicted jackpot probability. In Panel A, we report average excess

returns over the risk-free rate for these portfolios as well as the alphas estimated from three

different models: CAPM, 3-factor model, and 4-factor model.

The excess returns sharply drop in Decile 9 (0.03% per month) and Decile 10 (-0.62% per

month).

Institutional ownership

Barberis and Huang (BH) suggest that individual investors are more likely than institutions

to display a preference for stocks with lottery-like payoffs. Kumar (2009) finds that retail

investors exhibit a preference for stocks with lottery-like features, while institutions do not. We,

therefore, investigate the ownership structure of stocks sorted on the basis of DEATHP and

JACKPOTP. Institutional ownership is defined as the fraction of shares owned by institutions

in the Thomson Reuters Institutional Holdings database.

BH argue that limits to arbitrage could result in expected utility investors being unable or

unwilling to short-sell jackpot assets to exploit their low returns. We, therefore, test the

hypothesis that the jackpot effect is stronger when limits to arbitrage are high, using three

measures of limits to arbitrage: size, institutional ownership, and analyst coverage.

(1) Size: Small firms are defined as firms smaller than the NYSE 30% cut off, and large firms

are larger than the NYSE 70% cut off.

(2) Residual institutional ownership, (3) Residual analyst coverage explicitly control for size,

so that results for these variables are not just restatements of the results for size (because raw

values of these variables are highly correlated with size).

2018, Kyungsun Kim

Jackpot effect is much stronger in firms with low residual institutional ownership. We find

broadly similar results, although with smaller magnitudes, for residual analyst coverage. These

results demonstrate that the jackpot effect is concentrated amongst stocks with high limits to

arbitrage. As a consequence, high limits to arbitrage could help explain why these pricing

effects persist in the data.

Table 7, Panel A, presents pair-wise Spearman correlations between predicted distress from

the CHS model (DEATHP) and different measures of the out-of-sample probability of a jackpot

return. JACKPOTP, the predicted probability of a jackpot return from our baseline model, has

a correlation of 41.8% with the probability of distress.

In Panels B and C of Table 7, we examine the correlation in the returns of the jackpot and

distress strategies, and compare their exposures to the four standard factors. The first

specification in Panels B and C reports how returns of the two strategies co-vary with one

another. The results indicate a strong relation, with 32.5% of the time series variation in the

jackpot (distress) strategy return explained by the distress (jackpot) strategy return. In both

specifications, the alpha estimates decline sharply and become statistically insignificant.

2018, Kyungsun Kim

These results indicate that a significant relationship exists between distress and jackpot

strategies. Thus, a high probability of a jackpot return is a plausible explanation for the low

average returns of stocks with high default probability.

2018, Kyungsun Kim

Suppose that the CAPM holds conditionally:

𝑒𝑒 𝑒𝑒

E𝑡𝑡 𝑅𝑅𝑖𝑖,𝑡𝑡+1 = 𝛽𝛽𝑖𝑖𝑖𝑖𝑖𝑖 E𝑡𝑡 𝑅𝑅𝑚𝑚,𝑡𝑡+1

𝑒𝑒

E𝑅𝑅𝑖𝑖,𝑡𝑡+1 ̅ E𝑅𝑅𝑚𝑚,𝑡𝑡+1

= 𝛽𝛽𝑖𝑖𝑖𝑖 𝑒𝑒 𝑒𝑒

+ 𝐶𝐶𝐶𝐶𝐶𝐶(𝛽𝛽𝑖𝑖𝑖𝑖𝑖𝑖 , E𝑡𝑡 𝑅𝑅𝑚𝑚,𝑡𝑡+1 )

An asset can have a higher unconditional average return than predicted by the unconditional

CAPM, if its beta moves with the market risk premium.

Theoretically, it is well known that the conditional CAPM could hold perfectly, period by

period, even though stocks are mispriced by the unconditional CAPM. A stock’s conditional

alpha (or pricing error) might be zero, when its unconditional alpha is not, if its beta changes

through time and is correlated with the equity premium or with market volatility.

In contrast, we argue, first, that if the conditional CAPM truly holds, we should expect to

find only small deviations from the unconditional CAPM—much smaller than those observed

empirically. Second, we provide direct empirical evidence that the conditional CAPM does

not explain the B/M and momentum effects. That is:

(1) If the conditional CAPM holds, E𝑡𝑡−1 [𝑅𝑅𝑖𝑖𝑖𝑖 ] = 𝛽𝛽𝑡𝑡 𝛾𝛾𝑡𝑡 , we show that a stock’s

unconditional alpha depends primarily on the covariance between its beta and the market risk

premium, 𝛼𝛼 𝑢𝑢 ≈ 𝐶𝐶𝐶𝐶𝐶𝐶(𝛽𝛽𝑡𝑡 , 𝛾𝛾𝑡𝑡 ). This implied alpha will typically be quite small. However, we

argue that observed pricing errors are simply too large to be explained by time variation in

beta.

(2) Using the short-window regressions, we estimate time series of conditional alphas and

betas for size, B/M, and momentum portfolios from 1964 to 2001. The alpha estimates enable

a direct test of the conditional CAPM: average conditional alphas should be zero if the

CAPM holds, but instead we find they are large, statistically significant, and generally close

to the portfolios’ unconditional alphas.

⟹ Betas vary significantly over time but not enough to explain observed asset-pricing

anomalies. Although the short-horizon regressions allow betas to vary without restriction

from quarter to quarter and year to year, the conditional CAPM performs nearly as poorly as

the unconditional CAPM.

2018, Kyungsun Kim

✓ Campbell, and Vuolteenaho (2004)

The idea of “Fed model” is that stocks and bonds compete for space in investors’ portfolios. If

the yield on bonds rises, then the risk-adjusted yield on stocks must also rise to maintain the

competitiveness of stocks.

Consider the classic “Gordon growth model” which expresses the dividend-price ratio in

steady state as

𝐷𝐷𝑡𝑡

= 𝑅𝑅 − 𝐺𝐺

𝑃𝑃𝑡𝑡−1

where R is the long-term discount rate and G is the long-term growth rate of dividends. The

Fed model argues that the discount rate on stocks is the yield on bonds plus a proxy for the risk

premium of stocks over bonds. Gordon model implies that D/P should be independent of

inflation, but what if it is not the case?

One possibility is that inflation damages the real economy, and particularly the profitability

of the corporate sector. In this case real G might fall when inflation rises, justifiably driving up

the dividend-price ratio. A second possibility is that inflation makes the economy riskier or

investors more risk-averse, driving up the equity premium and thus the real discount rate R.

Modigliani and Cohn (1979) propose a more radical third hypothesis, that stock market

investors fail to understand the effect of inflation on nominal dividend growth rates and

extrapolate historical nominal growth rates even in periods of changing inflation.

First, subtract the riskless interest rate from both the discount rate and the growth rate of

dividends. We define the excess discount rate as 𝑅𝑅 𝑒𝑒 ≡ 𝑅𝑅 − 𝑅𝑅𝑓𝑓 and the excess dividend growth

rate as 𝐺𝐺 𝑒𝑒 ≡ 𝐺𝐺 − 𝑅𝑅𝑓𝑓 , where all quantities should again be either nominal or real. We

distinguish between the subjective expectation of irrational investors (superscript SUBJ) and

the objective expectations of rational investors (superscript OBJ).

As long as irrational investors simply use the present value formula with an erroneous

expected growth rate or discount rate, both sets of expectations must obey the accounting

identity of the Gordon growth model:

𝐷𝐷

= 𝑅𝑅 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 = 𝑅𝑅 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

𝑃𝑃

= −𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 + 𝑅𝑅𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 + (𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 )

In words, the dividend yield has three components: (i) the negative of objectively expected

excess dividend growth, (ii) the subjective risk premium, and (iii) a mispricing term that is due

to a divergence between the objective and subjective growth forecasts.

The first step is to show that 𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 = 𝑅𝑅𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐷𝐷/𝑃𝑃 tends to rise, not fall, and that 𝑅𝑅𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

tends to fall, not rise, with inflation, thus ruling out the rational justifications for the co-

movement of the dividend yield with inflation. The second step is to show that, consistent with

the Modigliani-Cohn view, high inflation coincides with underpricing caused by a positive

2018, Kyungsun Kim

To allow for time-varying discount rates, we use the log-linear dynamic valuation framework

of Campbell and Shiller (1988):

∞

−𝑘𝑘 𝑒𝑒 𝑒𝑒

𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑡𝑡−1 ≈ + 𝐸𝐸𝑡𝑡−1 � 𝜌𝜌 𝑗𝑗 �−∆𝑑𝑑𝑡𝑡+𝑗𝑗 + 𝑟𝑟𝑡𝑡+𝑗𝑗 �

1 − 𝜌𝜌

𝑗𝑗=0

where ∆𝑑𝑑 denotes log dividend growth, r denotes log stock return, ∆𝑑𝑑 𝑒𝑒 denotes ∆𝑑𝑑 less the

log risk-free rate for the period, and 𝑟𝑟 𝑒𝑒 denotes r less the log risk-free rate for the period; 𝜌𝜌(≈

0.97 ) and k are constant parameters. Comparing the Gordon growth model and Dynamic

Gordon model, ∑∞ 𝑗𝑗 𝑒𝑒

𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 𝑟𝑟𝑡𝑡+𝑗𝑗 is analogous to 𝑅𝑅𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 and 𝑅𝑅𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 , and

∑∞ 𝑗𝑗 𝑒𝑒

𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 ∆𝑑𝑑𝑡𝑡+𝑗𝑗 is analogous to 𝐺𝐺

𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂

and 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 ,depending on whether the

expectations taken are objective or subjective.

Following Campbell (1991), we combine the valuation framework with a VAR that predicts

stock returns. The first-order VAR includes the excess log return on the S&P 500 index over

the three-month Treasury bill (𝑟𝑟 𝑒𝑒 ), the cross-sectional equity risk premium of Polk et al. (2003)

(𝜆𝜆 ). The log dividend-price ratio (dy), and the exponentially smoothed moving average of

inflation (𝜋𝜋).

𝑗𝑗 𝑂𝑂𝑂𝑂𝑂𝑂 𝑒𝑒

We first estimate the term ∑∞ 𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 𝑟𝑟𝑡𝑡+𝑗𝑗 under objective expectations using the VAR

𝑗𝑗 𝑂𝑂𝑂𝑂𝑂𝑂

and then infer the objective expected growth rate − ∑∞ 𝑒𝑒

𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 ∆𝑑𝑑𝑡𝑡+𝑗𝑗 using the equation of

Dynamic Gordon model. The subjective risk premium is estimated as the fitted value (𝛾𝛾𝜆𝜆𝑡𝑡 ) of

𝑗𝑗 𝑂𝑂𝑂𝑂𝑂𝑂 𝑒𝑒

a regression of ∑∞ 𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 𝑟𝑟𝑡𝑡+𝑗𝑗 on the subjective risk-premium proxy 𝜆𝜆𝑡𝑡 . Mispricing, or the

difference between objective and subjective expected dividend growth, is the residual 𝜀𝜀𝑡𝑡 of

this regression. When stocks are subjectively perceived to be very risky, then the fitted value

𝛾𝛾𝜆𝜆𝑡𝑡 is high. In contrast, when stocks are underpriced, the residual 𝜀𝜀𝑡𝑡 is high. Together these

𝑗𝑗 𝑂𝑂𝑂𝑂𝑂𝑂

three series, − ∑∞ 𝑒𝑒

𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 ∆𝑑𝑑𝑡𝑡+𝑗𝑗 , 𝛾𝛾𝜆𝜆𝑡𝑡 , and 𝜀𝜀𝑡𝑡 , add up to log dividend yield.

Table 1 shows our VAR results. We regress the three components of dividend yield on

𝑗𝑗 𝑂𝑂𝑂𝑂𝑂𝑂

inflation. The regression coefficient of − ∑∞ 𝑒𝑒

𝑗𝑗=0 𝜌𝜌 𝐸𝐸𝑡𝑡−1 ∆𝑑𝑑𝑡𝑡+𝑗𝑗 on inflation is -11.25 with an 𝑅𝑅

2

of 95 percent, implying a positive, not negative, relation between rationally expected excess

dividend growth and inflation. The subjective risk premium seems largely unrelated to inflation.

Thus, we reject the rational hypotheses justifying the positive association of dividend yield and

inflation.

In contrast, our VAR results in Table 1 provide strong support to the Modigliani-Cohn (1979)

hypothesis. The regression coefficient of 𝜀𝜀𝑡𝑡 on inflation is strongly positive, and statistically

and economically significant.

2018, Kyungsun Kim

Modigliani and Cohn hypothesize that the stock market suffers from money illusion,

discounting real cash flows at nominal discount rates. In the absence of money illusion, CAPM

predicts that the risk compensation for one unit of beta among stocks, which is also called the

slope of the security market line, is always equal to the rationally expected premium of the

market portfolio of stocks over short-term bills.

We show that money illusion implies that, when inflation is low or negative, the

compensation for one unit of beta among stocks is larger (and the security market line steeper)

than the rationally expected equity premium.

Consider the classic “Gordon growth model” that equates the dividend price ratio with the

difference between the discount rate and expected growth:

𝐷𝐷𝑡𝑡

= 𝑅𝑅 − 𝐺𝐺

𝑃𝑃𝑡𝑡−1

where R is the long-term discount rate and G is the long-term growth rate of dividends, and all

quantities should be either nominal or real.

First, subtract the riskless interest rate from both the discount rate and the growth rate of

dividends. We define the excess discount rate as 𝑅𝑅𝑒𝑒 ≡ 𝑅𝑅 − 𝑅𝑅𝑓𝑓 and the excess dividend growth

rate as 𝐺𝐺 𝑒𝑒 ≡ 𝐺𝐺 − 𝑅𝑅𝑓𝑓 , where all quantities should again be either nominal or real. We

distinguish between the subjective expectation of irrational investors (superscript SUBJ) and

the objective expectations of rational investors (superscript OBJ).

2018, Kyungsun Kim

As long as irrational investors simply use the present value formula with an erroneous

expected growth rate or discount rate, both sets of expectations must obey the Gordon growth

model:

𝐷𝐷

= 𝑅𝑅 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 = 𝑅𝑅 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

𝑃𝑃

= −𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 + 𝑅𝑅𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 + (𝐺𝐺 𝑒𝑒,𝑂𝑂𝐵𝐵𝐵𝐵 − 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 )

Notice that mispricing error 𝜀𝜀 ≡ 𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 is specified in terms of excess yield, with

𝜀𝜀 < 0 indicating overpricing and 𝜀𝜀 > 0 underpricing. Notice also that the Gordon growth

model requires that the expected error in long-term growth model requires that the

expectational error in long-term growth rates, 𝐺𝐺 𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐺𝐺 𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 , be equal to the expectational

error in long-term expected returns, 𝑅𝑅 𝑒𝑒,𝑜𝑜𝑜𝑜𝑜𝑜 − 𝑅𝑅 𝑒𝑒,𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 .

Campbell and Voulteenaho (2004) formalize the Modigliani Cohn money-illusion story by

specifying that mispricing or expectational error is a linear function of past smoothed inflation:

With some assumptions that market makes no other type of systematic mistake in valuing

stocks, the above equation holds not only for the market but also for each individual stock:

𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂

𝜀𝜀𝑖𝑖 ≡ 𝐺𝐺𝑖𝑖 − 𝐺𝐺𝑖𝑖𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑅𝑅𝑖𝑖𝑒𝑒,𝑜𝑜𝑜𝑜𝑜𝑜 − 𝑅𝑅𝑖𝑖𝑒𝑒,𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = γ0 + 𝛾𝛾1 𝜋𝜋

equal across stocks, i.e., 𝜀𝜀𝑖𝑖 ≡ 𝜀𝜀𝑀𝑀 = γ0 + 𝛾𝛾1 𝜋𝜋.

Our final assumption is that investors behave according to CAPM to set required risk

premiums. This implies that the slope of the relation between the subjective return expectation

on an asset and that asset’s CAPM beta is equal to the subjective market premium:

𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

𝑅𝑅𝑖𝑖𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝛽𝛽𝑖𝑖 𝑅𝑅𝑀𝑀

(1979) money-illusion hypothesis. Substituting the subjective Sharpe-Lintner CAPM into the

equation of 𝜀𝜀𝑖𝑖 yields

𝑒𝑒,𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

𝜀𝜀𝑖𝑖 = 𝑅𝑅𝑖𝑖𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝛽𝛽𝑖𝑖 𝑅𝑅𝑀𝑀

Recognizing that market mispricing 𝜀𝜀𝑀𝑀 equals the wedge between objective and subjective

market premium results in

𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂

𝜀𝜀𝑖𝑖 = 𝑅𝑅𝑖𝑖𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝛽𝛽𝑖𝑖 [𝑅𝑅𝑀𝑀 − 𝜀𝜀𝑀𝑀 ]

2018, Kyungsun Kim

𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂

⟺ 𝛼𝛼𝑖𝑖𝑂𝑂𝑂𝑂𝑂𝑂 ≡ 𝑅𝑅𝑖𝑖𝑒𝑒,𝑂𝑂𝑂𝑂𝑂𝑂 − 𝛽𝛽𝑖𝑖 𝑅𝑅𝑀𝑀 = 𝜀𝜀𝑖𝑖 − 𝛽𝛽𝑖𝑖 𝜀𝜀𝑀𝑀

Above, 𝛼𝛼𝑖𝑖𝑂𝑂𝑂𝑂𝑂𝑂 is an objective measure of relative mispricing, called Jensen’s (1968) alpha.

Since mispricing for both the market and stock I is equal to the same linear function of expected

inflation, γ0 + 𝛾𝛾1 𝜋𝜋, we can write

The above equation predicts that the (conditional) Jensen’s alpha of a stock is a linear function

of inflation, the stock’s beta, and the interaction between inflation and the stock’s beta. If the

market suffers from money illusion, then when inflation is high a rational investor would

perceive a positive alpha for low-beta stocks and a negative alpha for high-beta stocks.

2018, Kyungsun Kim

✓ Savor, and Wilson (2014)

We show that asset prices behave very differently on days when important macroeconomic

news is scheduled for announcement.

We estimate stock market betas for all stocks using rolling windows of 12 months of daily

returns from 1964 to 2011. We then sort stocks into one of ten beta-decile value-weighted

portfolios. Figure 1 plots average realized excess returns for each portfolio against full-sample

portfolio betas separately for non-announcement days (square-shaped points and a dotted line)

and announcement days (diamond-shaped points and a solid line). The non-announcement-day

points show a negative relation between average returns and beta. In contrast, on announcement

days the relation between average returns and beta is strongly positive.

These results suggest that beta is after all an important measure of systematic risk. At times

when investors expect to earn important information about the economy, they demand higher

returns to hold higher-beta assets. Moreover, these announcement days represent periods of

much higher average excess returns and Sharpe ratios for the stock market and long-term

Treasury bonds. Savor and Wilson (2013) find that in the 1958-2009 period the average excess

daily return on a broad index of US stocks is 11.4 bps on announcement day versus 1.1 bps on

all other days. The non-announcement-day average excess return is not significantly different

from zero, while the announcement-day premium is highly statistically significant and robust.

These estimates imply that over 60% of the equity risk premium is earned on announcement

days, which constitute just 13% of the sample period.

2018, Kyungsun Kim

This paper examines the relation between stock returns and stock market volatility. We find

evidence that the expected market risk premium (the expected return on a stock portfolio minus

the Treasury bill yield) is positively related to the predictable volatility of stock returns. There

is also evidence that unexpected stock market returns are negatively related to the unexpected

change in the volatility of stock returns.

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