Risk, Return and Dividends

Abstract

We characterize the joint dynamics of dividends, expected returns, stochastic volatility, and prices. In particular, with a given dividend process, one of the processes of the expected return, the stock volatility, or the price-dividend ratio fully determines the other two. For example, together with cashflows, the stock volatility process fully determines the dynamics of the expected return and the price-dividend ratio. By parameterizing one or more of expected returns, volatility, or prices, common empirical specifications place strong, and sometimes counter-factual, restrictions on the dynamics of the other variables. Our relations are useful for understanding the risk-return trade-off, as well as characterizing the predictability of stock returns.

Keywords: risk-return trade-off, risk premium,stochastic volatility, predictability

JEL Classification: G12