# Asset Pricing. (Bureau News).

Nearly 75 members and guests of the NBER's Program on Asset
Pricing met in Cambridge on November 9. Organizers Luis M. Viceira and
Tuomo Vuolteenaho, both of NBER and Harvard University, chose these
papers to discuss:

Ravi Bansal, Duke University, and Robert F. Dittmar and Christian T. Lundblad, Indiana University, "Consumption, Dividends, and the Cross-Section of Equity Returns"

Discussant: Martin Lettau, New York University

Andrew Ang and Geert Bekaert, NBER and Columbia University, "Stock Return Predictability: Is It There?"

Discussant: Samuel Thompson, Harvard University

Jonathan Lewellen, MIT, "Predicting Returns with Financial Ratios"

Discussant: Robert F. Stambaugh, NBER and University of Pennsylvania

Joao F. Gomes and Lu Zhang, University of Pennsylvania, and Amir Yaron, NBER and University of Pennsylvania, "Asset Pricing Implications of Firms' Financing Constraints"

Discussant: John H. Cochrane, NBER and University of Chicago

Michael W. Brandt, NBER and University of Pennsylvania; John H. Cochrane; and Pedro Santa-Clara, University of California, Los Angeles, "International Risk Sharing is Better Than You Think (Or Exchange Rates Are Much Too Smooth)"

Discussant: Ravi Jagannathan, NBER and Northwestern University

Lubos Pastor University of Chicago, and Robert F. Stambaugh, "Liquidity Risk and Expected Stock Returns"

Discussant: Jiang Wang, NBER and MIT

A central economic idea is that an asset's risk premium is determined by its ability to insure against fluctuations in consumption (that is, by consumption beta). Consistent with this intuition, Bansal, Dittmar, and Lundblad show that a model with constant consumption betas does extremely well in capturing cross-sectional differences in risk premiums. More specifically, the authors present a dynamic general equilibrium model in which cross-sectional differences in an asset's consumption beta are determined by cross-sectional differences in the exposure of the asset's dividends to aggregate consumption - that is, by the consumption leverage of the asset's dividends. They measure this consumption leverage in one case as the stochastic cointegration parameter between dividends and consumption and in another by the covariance of ex-post dividend growth rates with the expected growth rate of consumption. Cross-sectional differences in this consumption leverage parameter can explain up to 65 percent of the cross-sectional variation in risk premiums across 31 portfolios - which include the market, 10 momentum-, 10 size-, and 10 book-to-market-sorted portfolios. The consumption leverage model can justify much of the observed value, momentum, and size-risk premium spreads. For this asset menu, empirical three-factor models (size, BM, and market factors, for example) can justify about 17 percent of the cross-sectional differences in risk premiums. Time-varying beta asset pricing models also have considerable difficulty justifying the cross-section of risk premiums for these assets.

Ang and Bekaert ask whether stock returns in France, Germany, Japan, the United Kingdom, and the United States are predictable by three instruments: the dividend yield, the earnings yield, and the short rate. The predictability regression is suggested by a present value model with earnings growth, payout ratios, and the short rate as state variables. The authors find the short rate to be the only robust short-run predictor of excess returns, and find little evidence of excess return predictability by earnings or dividend yields across all countries. There is no evidence of long-horizon return predictability once the authors account for finite sample influence. Cross-country predictability is stronger than predictability using local instruments. Finally, dividend and earnings yield predict future cashflow growth rates both in the United States and in other countries.

Lewellen reports on the predictive power of dividend yield, book to market, and the earnings-price ratio. He shows that previous studies overstate the bias in predictive regressions and consequently understate the forecasting power of the three financial ratios. Dividend yield predicts stock returns from 1946-97, as well as in various subperiods. Book-to-market and the earnings-price ratio predict returns during the shorter 1963-97 sample. The evidence remains strong despite the ratios' poor forecasting ability in recent years.

Gomes, Yaron, and Zhang ask whether firms' financing constraints are quantitatively important in explaining asset returns. To answer this question they first show that, for a large class of theoretical models, these constraints have a parsimonious representation amenable to empirical analysis. They find that financing frictions lower both the market Sharpe ratio and the correlation between the pricing kernel and returns. Consequently, these frictions significantly worsen the performance of investment-based asset pricing models. These results bring into question whether the asset pricing fluctuations, induced by the presence of the financing constraints, provide a realistic channel for the propagation mechanism in several macroeconomic models.

Exchange rates depreciate by the difference between the domestic and foreign marginal utility growths. Exchange rates vary a lot, as much as 10 percent per year. However, equity premiums imply that marginal utility growths vary much more, by at least 50 percent per year. This means that marginal utility growths must be highly correlated across countries -- international risksharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do -- exchange rates are thus much too smooth. Brandt, Cochrane, and Santa-Clara calculate an index of international risksharing that formalizes this intuition in the context of both complete and incomplete capital markets. Their results suggest that risksharing is indeed very high across several pairs of countries.

Pastor and Stambaugh investigate whether market-wide liquidity is a state variable important for asset pricing. They find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Their monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors.

Ravi Bansal, Duke University, and Robert F. Dittmar and Christian T. Lundblad, Indiana University, "Consumption, Dividends, and the Cross-Section of Equity Returns"

Discussant: Martin Lettau, New York University

Andrew Ang and Geert Bekaert, NBER and Columbia University, "Stock Return Predictability: Is It There?"

Discussant: Samuel Thompson, Harvard University

Jonathan Lewellen, MIT, "Predicting Returns with Financial Ratios"

Discussant: Robert F. Stambaugh, NBER and University of Pennsylvania

Joao F. Gomes and Lu Zhang, University of Pennsylvania, and Amir Yaron, NBER and University of Pennsylvania, "Asset Pricing Implications of Firms' Financing Constraints"

Discussant: John H. Cochrane, NBER and University of Chicago

Michael W. Brandt, NBER and University of Pennsylvania; John H. Cochrane; and Pedro Santa-Clara, University of California, Los Angeles, "International Risk Sharing is Better Than You Think (Or Exchange Rates Are Much Too Smooth)"

Discussant: Ravi Jagannathan, NBER and Northwestern University

Lubos Pastor University of Chicago, and Robert F. Stambaugh, "Liquidity Risk and Expected Stock Returns"

Discussant: Jiang Wang, NBER and MIT

A central economic idea is that an asset's risk premium is determined by its ability to insure against fluctuations in consumption (that is, by consumption beta). Consistent with this intuition, Bansal, Dittmar, and Lundblad show that a model with constant consumption betas does extremely well in capturing cross-sectional differences in risk premiums. More specifically, the authors present a dynamic general equilibrium model in which cross-sectional differences in an asset's consumption beta are determined by cross-sectional differences in the exposure of the asset's dividends to aggregate consumption - that is, by the consumption leverage of the asset's dividends. They measure this consumption leverage in one case as the stochastic cointegration parameter between dividends and consumption and in another by the covariance of ex-post dividend growth rates with the expected growth rate of consumption. Cross-sectional differences in this consumption leverage parameter can explain up to 65 percent of the cross-sectional variation in risk premiums across 31 portfolios - which include the market, 10 momentum-, 10 size-, and 10 book-to-market-sorted portfolios. The consumption leverage model can justify much of the observed value, momentum, and size-risk premium spreads. For this asset menu, empirical three-factor models (size, BM, and market factors, for example) can justify about 17 percent of the cross-sectional differences in risk premiums. Time-varying beta asset pricing models also have considerable difficulty justifying the cross-section of risk premiums for these assets.

Ang and Bekaert ask whether stock returns in France, Germany, Japan, the United Kingdom, and the United States are predictable by three instruments: the dividend yield, the earnings yield, and the short rate. The predictability regression is suggested by a present value model with earnings growth, payout ratios, and the short rate as state variables. The authors find the short rate to be the only robust short-run predictor of excess returns, and find little evidence of excess return predictability by earnings or dividend yields across all countries. There is no evidence of long-horizon return predictability once the authors account for finite sample influence. Cross-country predictability is stronger than predictability using local instruments. Finally, dividend and earnings yield predict future cashflow growth rates both in the United States and in other countries.

Lewellen reports on the predictive power of dividend yield, book to market, and the earnings-price ratio. He shows that previous studies overstate the bias in predictive regressions and consequently understate the forecasting power of the three financial ratios. Dividend yield predicts stock returns from 1946-97, as well as in various subperiods. Book-to-market and the earnings-price ratio predict returns during the shorter 1963-97 sample. The evidence remains strong despite the ratios' poor forecasting ability in recent years.

Gomes, Yaron, and Zhang ask whether firms' financing constraints are quantitatively important in explaining asset returns. To answer this question they first show that, for a large class of theoretical models, these constraints have a parsimonious representation amenable to empirical analysis. They find that financing frictions lower both the market Sharpe ratio and the correlation between the pricing kernel and returns. Consequently, these frictions significantly worsen the performance of investment-based asset pricing models. These results bring into question whether the asset pricing fluctuations, induced by the presence of the financing constraints, provide a realistic channel for the propagation mechanism in several macroeconomic models.

Exchange rates depreciate by the difference between the domestic and foreign marginal utility growths. Exchange rates vary a lot, as much as 10 percent per year. However, equity premiums imply that marginal utility growths vary much more, by at least 50 percent per year. This means that marginal utility growths must be highly correlated across countries -- international risksharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do -- exchange rates are thus much too smooth. Brandt, Cochrane, and Santa-Clara calculate an index of international risksharing that formalizes this intuition in the context of both complete and incomplete capital markets. Their results suggest that risksharing is indeed very high across several pairs of countries.

Pastor and Stambaugh investigate whether market-wide liquidity is a state variable important for asset pricing. They find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Their monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors.

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Publication: | NBER Reporter |
---|---|

Date: | Dec 22, 2001 |

Words: | 959 |

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