Cash-flow or Discount Risk? Evidence from the Cross-section of Present Values
Coauthor(s): Bingxu Chen
Realized returns comprise expected returns plus 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 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 important in explaining the variations of expected returns, (2) the CF innovation drives the variations of unexpected returns, and (3) they together account for 80% of the cross-sectional variance of the average stock returns.
Bingxu Chen "Cash-flow or Discount Risk? Evidence from the Cross-section of Present Values." , Columbia Business School, (2013).