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Bubbles or noise? Reconciling the results of broad-dividend variance-bounds tests


  • Garrett H. TeSelle


Recent research indicates that results of variance-bounds tests of stock price volatility may depend on the definition of cash flows deemed relevant to shareholders: Tests using regular (or "narrow") dividends repeatedly have suggested that stock prices fluctuate more than can be explained by a simple present value hypothesis, while some tests using "broad dividends" (i.e., narrow dividends plus proceeds from share liquidations) do not detect such excess price volatility. Researchers disagree as to the cause and meaning of these differences. This paper derives and analyzes the broad-dividend version of the present value hypothesis to show that under common assumptions, these differences in variance-bounds tests have only two possible causes: Either narrow-dividend tests have rejected the present value hypothesis because of bubbles (either rational bubbles, or "empirical" bubbles as might be effected by dividend-smoothing or dividend-nonpayment); or broad-dividend tests simply have lacked power to detect mispricing. Using simulation and results from previous studies, this paper demonstrates that the second possible cause -- the lack of power in broad-dividend tests -- most likely explains the differences between narrow- and broad-dividend variance-bounds tests.

Suggested Citation

  • Garrett H. TeSelle, 1998. "Bubbles or noise? Reconciling the results of broad-dividend variance-bounds tests," Finance and Economics Discussion Series 1998-42, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:1998-42

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    References listed on IDEAS

    1. West, Kenneth D, 1988. "Dividend Innovations and Stock Price Volatility," Econometrica, Econometric Society, vol. 56(1), pages 37-61, January.
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    3. Pontiff, Jeffrey, 1997. "Excess Volatility and Closed-End Funds," American Economic Review, American Economic Association, vol. 87(1), pages 155-169, March.
    4. Marsh, Terry A & Merton, Robert C, 1986. "Dividend Variability and Variance Bounds Tests for the Rationality ofStock Market Prices," American Economic Review, American Economic Association, vol. 76(3), pages 483-498, June.
    5. Hansen, Lars Peter & Sargent, Thomas J., 1980. "Formulating and estimating dynamic linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 7-46, May.
    6. Gilles, Christian & LeRoy, Stephen F, 1991. "Econometric Aspects of the Variance-Bounds Tests: A Survey," Review of Financial Studies, Society for Financial Studies, vol. 4(4), pages 753-791.
    7. Flood, Robert P & Hodrick, Robert J, 1990. "On Testing for Speculative Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 85-101, Spring.
    8. Cochrane, John H., 1991. "Volatility tests and efficient markets : A review essay," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 463-485, June.
    9. Diba, Behzad T & Grossman, Herschel I, 1988. "The Theory of Rational Bubbles in Stock Prices," Economic Journal, Royal Economic Society, vol. 98(392), pages 746-754, September.
    10. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
    11. Ackert, Lucy F & Smith, Brian F, 1993. " Stock Price Volatility, Ordinary Dividends, and Other Cash Flows to Shareholders," Journal of Finance, American Finance Association, vol. 48(4), pages 1147-1160, September.
    12. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-574, May.
    13. John B. Shoven, 1987. "The Tax Consequences of Share Repurchases and Other Non-Dividend Cash Payments to Equity Owners," NBER Chapters,in: Tax Policy and the Economy, Volume 1, pages 29-54 National Bureau of Economic Research, Inc.
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    Cited by:

    1. Taipalus, Katja, 2006. "Bubbles in the Finnish and US equities markets," Scientific Monographs, Bank of Finland, number 35/2006, November.

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