Two Trees: Asset Price Dynamics Induced by Market Clearing
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.
|Date of creation:||Nov 2003|
|Date of revision:|
|Publication status:||published as Cochrane, John, Francis A Longstaff, and Pedro Santa-Clara. "Two Trees." Review of Financial Studies 21 (2008): 247-385.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
- He, Hua & Leland, Hayne, 1993. "On Equilibrium Asset Price Processes," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 593-617.
- Jonathan Lewellen, 2002. "Momentum and Autocorrelation in Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 533-564, March.
- Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
- Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2001.
"The Value Spread,"
NBER Working Papers
8242, National Bureau of Economic Research, Inc.
- Tobias J. Moskowitz & Mark Grinblatt, .
"Do Industries Explain Momentum?,"
CRSP working papers
352, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- Ravi Bansal & Robert F. Dittmar & Christian T. Lundblad, 2005. "Consumption, Dividends, and the Cross Section of Equity Returns," Journal of Finance, American Finance Association, vol. 60(4), pages 1639-1672, 08.
- Lo, Andrew W. (Andrew Wen-Chuan) & MacKinlay, Archie Craig, 1955-., 1989.
"When are contrarian profits due to stock market overreaction?,"
3008-89., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Lo, Andrew W & MacKinlay, A Craig, 1990. "When Are Contrarian Profits Due to Stock Market Overreaction?," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 175-205.
- Andrew W. Lo & A. Craig MacKinlay, 1989. "When are Contrarian Profits Due to Stock Market Overreaction?," NBER Working Papers 2977, National Bureau of Economic Research, Inc.
- Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
- Tano Santos & Pietro Veronesi, 2001. "Labor Income and Predictable Stock Returns," NBER Working Papers 8309, National Bureau of Economic Research, Inc.
- Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
- Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
- Merton, Robert C., 1971.
"Optimum consumption and portfolio rules in a continuous-time model,"
Journal of Economic Theory,
Elsevier, vol. 3(4), pages 373-413, December.
- R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
- repec:rus:hseeco:52003 is not listed on IDEAS
- Longstaff, Francis A. & Piazzesi, Monika, 2004.
"Corporate earnings and the equity premium,"
Journal of Financial Economics,
Elsevier, vol. 74(3), pages 401-421, December.
- Cheng, Pao L & Grauer, Robert R, 1980. "An Alternative Test of the Capital Asset Pricing Model," American Economic Review, American Economic Association, vol. 70(4), pages 660-71, September.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:10116. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.