Back of the Envelope

Observations on the Theory and Empirics of Mathematical Finance

Discount Rates: I

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In January earlier this year John Cochrane gave the AFA Presidential Address titled ‘Discount Rates’, based on his paper of the same name. It’s a most fascinating paper (though am not sure one can say the same for the talk) surveying the time series and cross-section evidence on predictability of asset returns. He presents his efficient markets story for the evidence from empirical asset pricing literature in the last two decades. This is how the abstract reads:

Discount rate variation is the central organizing question of current asset pricing research. I survey facts, theories and applications. We thought returns were uncorrelated over time, so variation in price-dividend ratios was due to variation in expected cash-flows. Now it seems all price-dividend variation corresponds to discount-rate variation. We thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients and data sources. Discount-rate variation continues to change finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.

It’s a huge paper, and one can run a doctoral level empirical asset pricing course just around this paper. So we’ll go step by step.

The first part presents evidence on the predictability of asset returns – the time series facts. Since Fama-French (1988) it is eminently established that long-horizons asset returns are predictable. While the short and long-horizon regressions are mathematically equivalent, there is still debate over whether long-horizon (Lettau and Ludvigson (2001)) or short-horizon regressions (Ang and Bekaert (2007) contain more economic information. Cochrane claims that it’s only at the long-horizons – roughly coinciding with length of the business cycles. He goes on to argue that all variation in price-dividend ratio (read stock return volatility) comes from the variation in discount rates and not expected cash flows.

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Written by Vineet

July 9, 2011 at 11:46 am

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