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1

Price change: cash flow or discount

rate?

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Why do prices vary so much? Zheng

Zhenlong
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Introduction Zheng
Zhenlong

1970s view:
Expected returns dont move much over
time stocks are unpredictable.
Prices move on news of cashflow
(dividend).
CAPM works pretty well.
Beta derives from the covariance of
cashflows with market cashflows.

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Introduction Zheng
Zhenlong

All are dramatically different now.

1. Expected returns move a lot over time stocks
are predictable. (Long run, business cycle
correlation)
2. Prices move on news of discount rate changes.
3. We understand the cross-section with
multifactor models.
(a) A larger number of characteristics other
than beta are associated with expected returns
(b) To the extent we understand those patterns,
expected returns line up with nonmarket betas
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Introduction Zheng
Zhenlong

4. Betas derive from the covariance of discount

rates with market discount rates.
5. Facts are pushing us to the risk premium
view of the world, as opposed to the constant
expected return, cashflow view from the 1970s.
6. These are the facts underlying theoretical
modeling.
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Old Facts Zheng

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New View of facts Zheng

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Why D/P forecasts long Pricing

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horizon returns?
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Predictability of Dividend Pricing

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growth

P/D should forecast a dividend rise. Price high

relative to current dividends should mean that
future dividends will be higher.
Dividend growth is not predictable! The point
estimates are the wrong sign!
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Do low prices mean / Pricing

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reveal high returns?
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Predictability time- Pricing

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varying expected returns
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Inefficiency? Zheng
Zhenlong

Does this mean markets are inefficient? Is this

an invitation to buy low and sell high?
Not necessarily. Time varying risk premia are
possible.
Are expected returns higher in good times or in
bad times? (Bad, why?) business-cycle related
time-varying risk premium is certainly possible.
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Campbell-Shiller linearization Pricing

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of the one-period return

Intuition: higher returns come from higher prices
(higher valuations p-d), lower initial prices, or
higher dividends.
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The Campbell-Shiller present Pricing

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value identity

If both d and r are unforecastable, pd is

constant. If p-d varies at all, something must be
forecastable. The fact that d-p varies means that
we do not live in an iid world. (Plus no bubbles)
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Zheng
Zhenlong
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A Pervasive Phenomenon Zheng

Zhenlong

Stocks. Dividend yields forecast returns, not dividend

growth.
Treasuries. A rising yield curve signals better 1-year
returns for long-term bonds, not higher future interest
rates. Fed fund futures signal returns, not changes in
the funds rate.
Bonds. Much variation in credit spreads over time and
across firms or categories signals returns, not default
probabilities.
Foreign exchange. International interest rate spreads
signal returns, not exchange rate depreciation.
Houses. High price/rent ratios signal low returns, not
rising rents or prices that rise forever.
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Common element: business Pricing

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cycle
low prices, high returns in recessions. High
prices, low returns in booms
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Multivariate Challenges: Pricing

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More variables
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Understanding prices: short Pricing

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and long-run forecasts

Cay:
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The cross section Zheng

Zhenlong

5
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Value effect and factor Zheng

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Value (size, and bond Pricing

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factors)
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The Multidimensional Pricing

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Challenge
(Market, value, size), momentum, accruals, equity issues,
beta-arbitrage, credit risk, bond & equity market timing,
carry trade, put writing, liquidity provision,...
1. Which of these are independently important for
E(Re )?
(multiple regression)
2. Does E(Re ) spread correspond to new factors?
3. Do we need all the new factors? Or again, fewer
factors than
E(Re ) characteristics?
4. Why do prices move? Long run.
How to approach such a highly multidimensional
problem?
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Asset Pricing on Pricing

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Characteristics/Unication
1. Portfolio sorts are really cross-sectional
regressions
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Asset Pricing on Pricing

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Characteristics/Unication
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Theory classification Pricing

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Consumption/habits Zheng
Zhenlong
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Investment and Q Zheng

Zhenlong
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Challenges for theories Zheng

Zhenlong

Pervasive, coordinated risk premium in all

markets, especially unintermediated
Mean returns are associated with comovement.
Strong correlation with macroeconomics
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Arbitrages Zheng
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Arbitrages Zheng
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Price and volume in the tech Pricing

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bubble
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Bonds a cautionary tale Zheng

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Stocks (your endowment) in Pricing

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the crisis
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Alphas, betas, and Pricing

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performance evaluation

A hedge fund manager said, Exotic beta is my alpha.

I understand those systematic factors and know how to
trade them. My clients dont.
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Conclusion Zheng
Zhenlong

Discount rates vary over time and across assets a

lot more than you thought
Empirical: how. Theoretical: why. Applications: at
all.
Weve only started
How do you ask the right question?
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Zheng
Zhenlong