Cash-Flow or Discount-Rate Risk? Evidence from the Cross Section of Present Values
55 Pages Posted: 8 Dec 2013 Last revised: 6 Feb 2014
Date Written: November 15, 2013
Realized returns comprise (ex-ante) expected returns plus (ex-post) innovations, and consequently both expected returns and returns innovations can be broken down into components reflecting fluctuations in cash flow (CF) and discount rate (DR). I use a present-value model to identify the CF and DR risk factors which are latent from the time series and cross sections of price-dividend ratios. This setup accommodates models where CF risk dominates, like Bansal and Yaron (2004), and models where DR risk dominates, like Campbell and Cochrane (1999). I estimate the model on portfolios, which capture several of the most common cross-sectional anomalies, and decompose the expected and unexpected returns into CF and DR components along both time-series and cross-sectional dimensions. I find that (1) the DR risk is more likely to explain the variations of expected returns, (2) the CF risk drives the variations of unexpected returns, and (3) together they account for over 80% of the cross-sectional variance of the average stock returns.
Keywords: Time-varying Risk, Conditional Capital Asset Pricing Model, Predictability, Present Value, Cross-sectional Anomalies
JEL Classification: G12, C51, C33
Suggested Citation: Suggested Citation