Essays on Stock Prices and Equity Premium
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This dissertation studies the role of cash flow in explaining stock price variations and the determination of equity premium after correcting for the measurement error of cash flow growth. In Chapter 1, we incorporate price-total payout (dividends plus repurchases) ratio into the models of Binsbergen and Koijen (2010) and Campbell and Ammer (1993) to reassess the role of cash flow in stock price movement. We find that the existing results of a high persistence in expected returns and a strong dependence of stock price variation on discount rates are partly attributable to the use of price-dividend ratio with measurement error as a predictor of stock returns. The incorporation of price-total payout ratio enables the models i) to improve an in-sample goodness of fit for return and cash flow growth, ii) to produce a lower persistence of expected returns, which leads to a smaller shock to stock prices from the discount rate channel, iii) to show a higher contribution of cash flow channel to stock price movement in terms of variations in price-cash flow ratio and unexpected return. These results apply to medium and large cap portfolios as well as to aggregate market index. In Chapter 2, we explore the effects on stock market variation of other factors than stock repurchases that could account for the non-stationarity of price-dividend ratio by incorporating regime shifts in the mean of price-total payout ratio into the models of Binsbergen and Koijen (2010) and Campbell and Ammer (1993). Compared to the results of Chapter 1, we achieve i) an improvement in in-sample goodness of fit for return and cash flow growth, ii) a lower persistence and higher volatility of expected returns, iii) stronger role of cash flow channel in stock market variation, all of which show that not only stock repurchases but also other structural factors such as persistent decline in consumption volatility affecting the relationship between stock prices and cash flows should be taken into account when we attempt to investigate the sources of stock price variations. In Chapter 3, we incorporate price-total payout ratio and endogenously generated consumption volatility with regime shifts into the dynamic asset pricing model of Bansal, Kiku, Shaliastovich, and Yaron (2014) (hereafter, “BKSY model”), which stresses the role of a sizable positive risk premium from the macroeconomic volatility channel in explaining the equity premium by introducing the volatility risk into traditional consumption-based asset pricing model. Our extension of the BKSY model provides a different identification of the consumption volatility risk by including the effects of the economic agent’s revision of expectation on the volatility states on each of three channels to determine the equity premium. From annual samples of 1930 to 2015, we find that our model shows a much smaller contribution of the consumption volatility risk to the total equity premium, most of which is now explained by the cash flow risk. This finding applies to cross-sectional portfolio returns as well as to aggregate market index return. Our model also indicates that the consumption volatility risk is not large enough to reverse a negative correlation between equity return and human capital return.
- Economics