Time Variation in Cash Flows and Discount Rates

Abstract

The relative contributions of cash flow and discount rate news to the conditional variance of market returns exhibit significant variation over time. We identify lagged changes in PPI inflation as the main macroeconomic determinant of this time variation. Cash flow betas of value stocks increase following an increase in inflation, suggesting that investors should either tilt their portfolios away from high cash-flow-risk stocks or hedge this risk after observing increasing inflation.

Keywords: Return decomposition, Dynamic conditional correlation model, Cash flow risk, Discount rate risk, Inflation

JEL Classification: G10, E31, G12