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.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
10116.
Length: Date of creation: Nov 2003 Date of revision: Handle: RePEc:nbr:nberwo:10116
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Pavlova, Anna & Rigobon, Roberto, 2003.
"Asset Prices and Exchange Rates,"
Working papers
4322-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
[Downloadable!]
Pavlova, Anna & Rigobon, Roberto, 2004.
"Asset Prices and Exchange Rates,"
Working papers
4322-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
[Downloadable!]
Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2003.
"The Value Spread,"
Journal of Finance,
American Finance Association, vol. 58(2), pages 609-642, 04.
[Downloadable!] (restricted)
Other versions:
Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2001.
"The Value Spread,"
NBER Working Papers
8242, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
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