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Stock Return and Cash Flow Predictability: The Role of Volatility Risk

  • Tim Bollerslev

    ()

    (Duke University, NBER and CREATES)

  • Lai Xu

    ()

    (Duke University)

  • Hao Zhou

    ()

    (Federal Reserve Board)

We examine the joint predictability of return and cash flow within a present value framework, by imposing the implications from a long-run risk model that allow for both time-varying volatility and volatility uncertainty. We provide new evidence that the expected return variation and the variance risk premium positively forecast both short-horizon returns and dividend growth rates. We also confirm that dividend yield positively forecasts long-horizon returns, but that it cannot forecast dividend growth rates. Our equilibrium-based “structural” factor GARCH model permits much more accurate inference than the reduced form VAR and univariate regression procedures traditionally employed in the literature. The model also allows for the direct estimation of the underlying economic mechanisms, including a new volatility leverage effect, the persistence of the latent long-run growth component and the two latent volatility factors, as well as the contemporaneous impacts of the underlying “structural” shocks.

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Paper provided by Department of Economics and Business Economics, Aarhus University in its series CREATES Research Papers with number 2012-51.

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Length: 60
Date of creation: 16 Nov 2012
Date of revision:
Handle: RePEc:aah:create:2012-51
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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