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Two Trees

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  • John H. Cochrane
  • Francis A. Longstaff
  • Pedro Santa-Clara

Abstract

We solve a model with two i.i.d. Lucas trees. Although the corresponding one-tree model produces a constant price-dividend ratio and i.i.d. returns, the two-tree model produces interesting asset-pricing dynamics. Investors want to rebalance their portfolios after any change in value. Because the size of the trees is fixed, prices must adjust to offset this desire. As a result, expected returns, excess returns, and return volatility all vary through time. Returns display serial correlation and are predictable from price-dividend ratios. Return volatility differs from cash-flow volatility, and return shocks can occur without news about cash flows. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

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Bibliographic Info

Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 21 (2008)
Issue (Month): 1 (January)
Pages: 347-385

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Handle: RePEc:oup:rfinst:v:21:y:2008:i:1:p:347-385

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References

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  1. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, American Finance Association, vol. 51(1), pages 55-84, March.
  2. Roberto Rigobon & Anna Pavlova, 2004. "Asset Prices and Exchange Rates," Econometric Society 2004 North American Winter Meetings 579, Econometric Society.
  3. Francis Longstaff & Monika Piazzesi, 2003. "Corporate Earnings and the Equity Premium," NBER Working Papers 10054, National Bureau of Economic Research, Inc.
  4. Tano Santos & Pietro Veronesi, 2001. "Labor Income and Predictable Stock Returns," NBER Working Papers 8309, National Bureau of Economic Research, Inc.
  5. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, Econometric Society, vol. 41(5), pages 867-87, September.
  6. Harald Hau & Helene Rey, 2004. "Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?," NBER Working Papers 10476, National Bureau of Economic Research, Inc.
  7. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 363-84, March.
  8. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
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Citations

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Cited by:
  1. Nicolae Gârleanu & Stavros Panageas & Jianfeng Yu, 2013. "Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion," NBER Working Papers 19381, National Bureau of Economic Research, Inc.
  2. Coeurdacier, Nicolas & Guibaud, Stéphane, 2006. "International Portfolio Diversification Is Better Than You Think," ESSEC Working Papers, ESSEC Research Center, ESSEC Business School DR 06013, ESSEC Research Center, ESSEC Business School.
  3. repec:spo:wpecon:info:hdl:2441/c8dmi8nm4pdjkuc9g70969520 is not listed on IDEAS
  4. repec:onb:oenbwp:y::i:154:b:1 is not listed on IDEAS
  5. Roussanov, Nikolai, 2014. "Composition of wealth, conditioning information, and the cross-section of stock returns," Journal of Financial Economics, Elsevier, Elsevier, vol. 111(2), pages 352-380.
  6. Santos, Tano & Veronesi, Pietro, 2010. "Habit formation, the cross section of stock returns and the cash-flow risk puzzle," Journal of Financial Economics, Elsevier, Elsevier, vol. 98(2), pages 385-413, November.
  7. Sylvain, Serginio, 2014. "Does Human Capital Risk Explain The Value Premium Puzzle?," MPRA Paper 54551, University Library of Munich, Germany.
  8. repec:spo:wpmain:info:hdl:2441/c8dmi8nm4pdjkuc9g70969520 is not listed on IDEAS
  9. Tarek Alexander Hassan, 2010. "Country Size, Currency Areas, and International Asset Returns," 2010 Meeting Papers, Society for Economic Dynamics 365, Society for Economic Dynamics.

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