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Two Trees

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

We solve a model with two “Lucas trees.†Each tree has i.i.d. dividend growth. The investor has log utility and consumes the sum of the two trees’ dividends. This model produces interesting asset-pricing dynamics, despite its simple ingredients. Investors want to rebalance their portfolios after any change in value. Since the size of the trees is fixed, however, 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 in the time series and in the cross section. Return volatility can be greater than the volatility of cash flows, giving the appearance of “excess volatility.†Returns can be cross-correlated even when the cash flows are independent, giving the appearance of “contagion†or “spurious comovement.â€

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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt6mt207w2.

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Date of creation: 01 Oct 2004
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Handle: RePEc:cdl:anderf:qt6mt207w2
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Web page: http://www.escholarship.org/repec/anderson_fin/

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  1. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  2. Francis Longstaff & Monika Piazzesi, 2003. "Corporate Earnings and the Equity Premium," NBER Working Papers 10054, National Bureau of Economic Research, Inc.
  3. Hau, Harald & Rey, Hélène, 2004. "Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows and Exchange Rates?," CEPR Discussion Papers 4517, C.E.P.R. Discussion Papers.
  4. Roberto Rigobon & Anna Pavlova, 2004. "Asset Prices and Exchange Rates," Econometric Society 2004 North American Winter Meetings 579, Econometric Society.
  5. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  6. 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.
  7. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
  8. Tano Santos & Pietro Veronesi, 2001. "Labor Income and Predictable Stock Returns," NBER Working Papers 8309, National Bureau of Economic Research, Inc.
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