Menzly, Santos and Veronesi, Understanding Menzly, Santos and Veronesi, Understanding Predictability

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Transcript of Menzly, Santos and Veronesi, Understanding Menzly, Santos and Veronesi, Understanding Predictability

  • Menzly, Santos and Veronesi, Understanding Predictability

    Presented by Jaewon Choi

    October 9, 2007

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Overview

    Questions

    Why the return predicting power of dividend yield is week Why the dividend growth is almost non-predictable

    General equilibrium model

    Habit persistence Time-varying dividend growth through cash flow modeling

    Main intuition of the model

    Time-varying risk preference induces the standard positive relationship between dividend yield and future return Time-varying dividend growth induces a negative relationship between dividend yield and future return

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Model : Preferences

    Representative consumer maximizing

    E [

    ∫ ∞ 0

    e−ρt log(Ct − Xt)dt]

    Xt : External habit level.

    Surplus/consumption ratio St

    St = Ct − Xt

    Ct

    Inverse surplus Yt = 1 St

    = 11−(Xt/Ct) follows

    dYt = k(Y − Yt)dt − α(Yt − λ)(dct − Et [dct ])

    Log consumption ct = log(Ct) follows

    dct = µcdt + σcdB 1 t

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Cash Flow Model

    n risky financial assets paying a dividend rate {D it}ni=1. D0t : Non-financial income flow.

    In equilibrium, Ct = Σ n i=0D

    i t

    Share of consumption for each asset s it = D it Ct

    ds it = φ i (s i − s it)dt + s itσi(st)dB′t

    Covariance between share and consumption growth

    Covt( ds it s it , dCt Ct

    ) = θiCF − Σnj=0θ j CF s

    j t

    Then dividend growth is

    dδit = µ i D(st)dt + σ

    i D(st)dB

    ′ t

    µiD(st) = µc + φ i (

    s i

    s it − 1)− 1

    2 σi(st)σ

    i(st) ′

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Prices - Total Wealth Portfolio

    Price of asset g paying Dgτ = s g τ Cτ at time τ

    Pgt = Et [

    ∫ ∞ t

    e−ρ(τ−t)[ uc(Cτ − Xτ ) uc(Ct − Xt)

    ]Dgτ dτ ]

    = Ct Yt

    Et [

    ∫ ∞ t

    e−ρ(r−t)sgτ Yτdτ ]

    Total wealth portfolio ( Dgτ = Cτ ) :

    PTWt Ct

    = 1

    ρ ( ρ+ kY St ρ+ k

    )

    Mean excess return and volatility

    µTWR (St) = [1 + α(1− λSt)]σTWR (St)σc

    σTWR (St) = [1 + kY St(1− λSt)α

    kY St + ρ ]σc

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Prices - Individual Securities

    Assume all assets have equal cash flow risk, Cov(dδit , dct) = σ

    2 c .

    Then dividend yield is P it D it

    = ai0 + a i 1St + a

    i 2

    s i

    s it + ai3

    s i

    s it St

    When dividend share s i

    s it high,

    P it D it

    is high.

    Expected return

    Et [dR i t ] = [1 + α(1− λSt)](1 +

    kYStα(1−λSt) kYSt+ρ[1+f (s i/s it )]

    )σ2c f (·) is a decreasing function. Positive relationship between dividend share s

    i

    s it and expected excess return.

    It weakens the predicting power of dividend yield.

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Prices - Individual Securities

    Rewriting expected return,

    Et [dR i t ] = b

    i 0(St) + b

    i 1(St)

    D it P it

    + bi2(St) C it P it

    Dependence on the speed of mean aversion φi . When φi is low, bi1 is greater than b

    i 2. This is because the

    effect of dividend share s i

    s it is more pronounced when the

    dividend share is persistent.

    Expected log dividend growth

    Et [dδ i ] = mi0(St , st) + m

    i 1(St)

    P it D it

    mi1(St) = φi

    ai2+a i 3St

    St in m i 1(St) and

    P it D it

    go in the opposite direction

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Data

    Quarterly data from CRSP. Sample period 1947-2001.

    20 value-weighted industry portfolios

    Cash flow variable s it = D i t/Ct constructed using

    dividend/share repurchases.

    Choice of parameters

    Match basic moments of the market portfolio Share process parameters from time-series linear regressions

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Model Parameters

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Predictability of Dividend Growth

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Predictability of Dividend Growth - Simulation

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Predictability of Stock Returns

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Predictability of Stock Returns - Simulation

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability

  • Discussion

    Key assumptions in the theory

    Dividend share is stationary. Consumption growth is not predictable so the dividend growth is forced to be predictable

    Statistical issue

    Overlapping samples (Finite sample property is not very good) Persistent regressor (Boudoukh, Richardson and Whitelaw 2006)

    overlapping samples

    Presented by Jaewon Choi Menzly, Santos and Veronesi, Understanding Predictability