Expected Returns and Dividend Growth Rates Implied in Derivative Markets

Abstract:     
The dividend-price ratio is a noisy proxy for expected returns in the presence of time-varying expected dividend growth rates. This paper uses a new and forward-looking measure of dividend growth rates extracted from S&P 500 futures and options to correct the dividend-price ratio for changes in expected dividend growth rates. For the period from January 1994 through June 2011, I find that the dividend growth rates implied in derivative markets reliably forecast future dividend growth rates, and the corrected dividend-price ratio predicts S&P 500 returns substantially better than the uncorrected dividend-price ratio. The forecasting relation between the corrected dividend-price ratio and returns is statistically significant and remarkably stable. Decomposing variance of the dividend-price ratio, I show that a substantial portion of price movements is attributable to the time-varying value of expected dividend growth rates. Expected dividend growth rates are also highly correlated with expected returns. The empirical results depend importantly on the simultaneous use of futures and options in estimating implied dividend growth rates.

Number of Pages in PDF File: 73

Keywords: present value models, dividend-price ratio, return predictability, derivatives

JEL Classification: G12, G13

working papers series