Advanced Search
MyIDEAS: Login

Two Trees: Asset Price Dynamics Induced by Market Clearing

Contents:

Author Info

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

Abstract

If stocks go up, investors may want to rebalance their portfolios. But investors cannot all rebalance. Expected returns may need to change so that the average investor is still happy to hold the market portfolio despite its changed composition. In this way, simple market clearing can give rise to complex asset market dynamics. We study this phenomenon in a very simple model. Our model has two Lucas trees.' Each tree has i.i.d.dividend growth, and the representative investor has log utility. We are able to give analytical solutions to the model. Despite this simple setup, price-dividend ratios, expected returns, and return variances vary through time. A dividend shock leads to underreaction' in some states, as expected returns rise and prices slowly adjust, and overreaction' in others. Expected returns and excess returns are predictable by price-dividend ratios in the time series and in the cross section, roughly matching value effects and return forecasting regressions. Returns generally display positive serial correlation and negative cross-serial correlation, leading to 'momentuem,' but the opposite signs are possible as well. A shock to one asset's dividend a.ects the price and expected return of the other asset, leading to substantial correlation of returns even when there is no correlation of cash flows and giving the appearance of contagion.' Market clearing allows the inverse portfolio' problem to be solved, in which the weights of the assets in the market portfolio are inverted' to solve for the parameters of the assets' return generating process.

(This abstract was borrowed from another version of this item.)

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://gsbwww.uchicago.edu/research/workshops/finance/two%20trees.pdf
Our checks indicate that this address may not be valid because: 404 Not Found (http://gsbwww.uchicago.edu/research/workshops/finance/two%20trees.pdf [301 Moved Permanently]--> https://gsbwww.uchicago.edu/research/workshops/finance/two%20trees.pdf). If this is indeed the case, please notify (David K. Levine)
Download Restriction: no

Bibliographic Info

Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 666156000000000355.

as in new window
Length:
Date of creation: 10 Nov 2003
Date of revision:
Handle: RePEc:cla:levrem:666156000000000355

Contact details of provider:
Web page: http://www.dklevine.com/

Related research

Keywords:

Other versions of this item:

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Lo, Andrew W & MacKinlay, A Craig, 1990. "When Are Contrarian Profits Due to Stock Market Overreaction?," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 175-205.
  2. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  3. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  4. Jonathan Lewellen, 2002. "Momentum and Autocorrelation in Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 533-564, March.
  5. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
  6. He, Hua & Leland, Hayne, 1993. "On Equilibrium Asset Price Processes," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 593-617.
  7. Tobias J. Moskowitz & Mark Grinblatt, . "Do Industries Explain Momentum?," CRSP working papers 480, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  8. Ravi Bansal & Robert F. Dittmar & Christian T. Lundblad, 2005. "Consumption, Dividends, and the Cross Section of Equity Returns," Journal of Finance, American Finance Association, vol. 60(4), pages 1639-1672, 08.
  9. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  10. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
  11. repec:rus:hseeco:52003 is not listed on IDEAS
  12. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2003. "The Value Spread," Journal of Finance, American Finance Association, vol. 58(2), pages 609-642, 04.
  13. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  14. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-84, March.
  15. Tano Santos & Pietro Veronesi, 2001. "Labor Income and Predictable Stock Returns," NBER Working Papers 8309, National Bureau of Economic Research, Inc.
  16. Longstaff, Francis A. & Piazzesi, Monika, 2004. "Corporate earnings and the equity premium," Journal of Financial Economics, Elsevier, vol. 74(3), pages 401-421, December.
  17. Cheng, Pao L & Grauer, Robert R, 1980. "An Alternative Test of the Capital Asset Pricing Model," American Economic Review, American Economic Association, vol. 70(4), pages 660-71, September.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Theodoros Diasakos, 2008. "Comparative Statics of Asset Prices," Carlo Alberto Notebooks 72, Collegio Carlo Alberto, revised 2011.
  2. Frieder, Laura, 2008. "Investor and price response to patterns in earnings surprises," Journal of Financial Markets, Elsevier, vol. 11(3), pages 259-283, August.
  3. Francis A. Longstaff, 2004. "Financial Claustrophobia: Asset Pricing in Illiquid Markets," NBER Working Papers 10411, National Bureau of Economic Research, Inc.
  4. Johnson, Timothy C., 2006. "Dynamic liquidity in endowment economies," Journal of Financial Economics, Elsevier, vol. 80(3), pages 531-562, June.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:cla:levrem:666156000000000355. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (David K. Levine).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.