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Valuing Equity when Discounted Cash Flows are Markov

In: Nonlinear Financial Econometrics: Markov Switching Models, Persistence and Nonlinear Cointegration

Author

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  • Jeremy Berkowitz

Abstract

In the absence of arbitrage opportunities, the value of a claim that is expected to pay a stream of payments d t is equal to its discounted expected cash flow. This result is a consequence of the martingale representation established in Harrison and Kreps (1979) and Harrison, Pliska (1981). Yet for valuing stocks, no formal methods of implementing the present value model are in widespread use. A great deal of attention has been focused on valuing individual equities cross-sectionally from a small set of factors. The CAPM, the Consumption-based CAPM and the APT are all models in which asset price risk and hence return are driven by a small number of state variables. These models have been subject to countless empirical investigations and have generally been rejected for US equity and bond returns (e.g., Hansen and Singleton (1982), Gibbons, Ross and Shanken (1989), Hansen and Jagannathan (1991), Ferson and Harvey (1992)).

Suggested Citation

  • Jeremy Berkowitz, 2011. "Valuing Equity when Discounted Cash Flows are Markov," Palgrave Macmillan Books, in: Greg N. Gregoriou & Razvan Pascalau (ed.), Nonlinear Financial Econometrics: Markov Switching Models, Persistence and Nonlinear Cointegration, chapter 1, pages 3-20, Palgrave Macmillan.
    • Handle: RePEc:pal:palchp:978-0-230-29521-6_1
    DOI: 10.1057/9780230295216_1
    as

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