From rjaganna@nwu.edu Wed Jul 19 16:02:35 2000 Received: from lulu.it.northwestern.edu (lulu.acns.nwu.edu [129.105.16.54]) by ellen.mpls.frb.fed.us (980427.SGI.8.8.8/970903.SGI.AUTOCF) via SMTP id QAA13340 for ; Wed, 19 Jul 2000 16:02:19 -0500 (CDT) Received: (from mailnull@localhost) by lulu.it.northwestern.edu (8.8.7/8.8.7) id QAA03886; Wed, 19 Jul 2000 16:01:07 -0500 (CDT) Received: from fin18338a (bp194-197.kellogg.nwu.edu [129.105.194.197]) by lulu.acns.nwu.edu via smap (V2.0) id xma003394; Wed, 19 Jul 00 15:59:51 -0500 Message-Id: <4.2.0.58.20000719155908.00d97240@lulu.acns.nwu.edu> X-Sender: rja235@lulu.acns.nwu.edu X-Mailer: QUALCOMM Windows Eudora Pro Version 4.2.0.58 Date: Wed, 19 Jul 2000 16:00:16 -0500 To: "Ellen R. McGrattan" , a-shcherbina@nwu.edu From: Ravi Jagannathan Subject: suggested changes In-Reply-To: <3975FE5A.41C6@ellen.mpls.frb.fed.us> Mime-Version: 1.0 Content-Type: text/plain; charset="iso-8859-1"; format=flowed Content-Transfer-Encoding: quoted-printable Status: RO Suggested changes: Page 2: Change the first full sentence to: "With a real interest rate of 2.9% per year on short term borrowings they estimate that a reasonable equity risk premium for would be no more than 0.25% per year." Change, "This prediction falls far short of actual payoff differences" to "Their calculation of what would be reasonable falls far short of the historically realized equity premium." Change the sentence, "(See Kocherlakota)" to "As Kocherlakota (1996) observes in his survey of this literature, the large returns equities have earned over the past 200 years relative to short term bonds is still a "puzzle" that academics are trying to figure out". Change "We argue that curent data" to "We argue that the equity premium in the future is more likely to be in line with what Mehra and Prescott (1985) considered would be reasonable compensation for risk bearing only". Change "We use a simple asset pricing formula.." to "In order come up with a reasonable estimate for the future equity premium, we use a simple valuation model -- the dividend discount model that has been popular in both the academic and practitioner literature. The model gives the value of stocks as a function of the expected growth rate in dividends in the future, future interest rates and the future equity premium. We use this model, along with the current level of stock prices to back out the implied equity premium as a function of future interest rates and dividend growth rates." Change "The result for reasonable assumptions.." to "Given the current level of stock prices, for reasonable assumptions regarding the future growth rate in dividends and future interest rates, this model implies a future equity premium of about 1.6% per year. This is far below what equities earned over bonds during the past century. " Continue with "This estimate is more in line.". Page 7, section "3. How Large Should The Equity Premium Be?" Start the section with the following paragraph: "In order to answer the question "what is a reasonable value for the equity risk premium?" we need to characterize the nature of the risk in equities and make some assumptions regarding the risk tolerances of investors. Mehra and Prescott (1985) came up with an answer to this question by making some assumptions about how investors would choose between different types of lotteries. As pointed out earlier, they concluded that a reasonable equity premium would be about 0.25%. In this section we explain how Mehra and Prescott reached that conclusion. Since this section is some what more technically demanding, a reader who is not interested in the details of the Mehra-Prescott calculations may skip the rest of this section and proceed directly to Section 4 without loss of continuity." 4. Estimates for the Future The first paragraph may be deleted and we may start with 4.1 The Benchmark Calcuation. Page 11: state the equation in words, right after the equation in symbols: equity premium current dividend yield + expected future dividend growth rate - risk free interest rate. Page 13 -- Adjusted Dividend Yield We can state the intuition behind this as follows: "Consider an investor who buys all the stocks of a firm, receives cash dividends, participates fully in stock buy-backs, and takes up the entire amount of any new issues in the future. For such an investor the benefit, in the form of future cash flow, would be Cash Dividends + Repurchases - New Issues. We call this as the Broad Measure of Dividends. The dividend discount model will value the shares correctly even when the broad measure of dividend is used instead. What is important is that the growth rate used corresponds to the dividend measure used. Which one is more suitable -- depends on which one is more stable and is closer to the "constant perpetual growth rate assumption". Page 20 "5. Conclusions" Please change "For stocks, we need to forecast.." to "For stocks we need to forecast the risk free interest rate, the equity premium as well as future dividends. The risk free interest rate is known. Both future dividends as well as future equity premium are unknown. Keeping the interest rate constant, stock prices would go up when expectations about future dividends go up or when the required equity premium go down. In general a run up in stock prices may be due to both effects. In this article we try to disentangle the two effects. Our calculations show that stocks are unlikely to earn as much in the future as they have in the past." At 02:15 PM 7/19/2000 -0500, Ellen R. McGrattan wrote: >Ravi and Anna -- > > Here is a new draft of the paper taking into account >the comments you sent Ravi. I am giving a copy to Art >who is going to probably ask Urban Jermann, Andy Atkeson >and Narayana Kocherlakota to review it along with the >paper that Ed and I wrote. They will probably get something >back to us in 2 or 3 weeks. > > >Ellen Ravi Jagannathan Finance Department Kellogg Graduate School of Management Northwestern University Evanston IL 60208-2001 (847)-491-8338 (voice) (847)-491-5719 (fax) From rjaganna@nwu.edu Fri Jul 21 15:45:41 2000 Received: from lulu.it.northwestern.edu (lulu.acns.nwu.edu [129.105.16.54]) by ellen.mpls.frb.fed.us (980427.SGI.8.8.8/970903.SGI.AUTOCF) via SMTP id PAA18942 for ; Fri, 21 Jul 2000 15:45:23 -0500 (CDT) Received: (from mailnull@localhost) by lulu.it.northwestern.edu (8.8.7/8.8.7) id PAA10990 for ; Fri, 21 Jul 2000 15:44:09 -0500 (CDT) Received: from fin18338a (bp194-197.kellogg.nwu.edu [129.105.194.197]) by lulu.acns.nwu.edu via smap (V2.0) id xma009991; Fri, 21 Jul 00 15:41:39 -0500 Message-Id: <4.2.0.58.20000721154057.00d4ba00@lulu.acns.nwu.edu> X-Sender: rja235@lulu.acns.nwu.edu X-Mailer: QUALCOMM Windows Eudora Pro Version 4.2.0.58 Date: Fri, 21 Jul 2000 15:41:26 -0500 To: erm (Ellen R. McGrattan) From: Ravi Jagannathan Subject: Abby Cohen's Forecasts -- Details Mime-Version: 1.0 Content-Type: text/plain; charset="us-ascii"; format=flowed Status: RO Forecasts Made By Abby Joseph Cohen, January 1999 Publication date: January 13, 1999 S&P500DJIA Average Expectation for December 199913009850 Index on January 7, 199912709538 Capital Gains for 52 weeks prorated (52/51)2.41%3.34% Dividend Yield (Approximate, a year back)1.33%1.65% Expected Total Return -- 52 weeks3.74%4.99% One year riskless rate Approx4.25%4.25% Risk premium-0.51%0.74% Expectations maybe conservative -- may be forecasting levels that the indexes will most likely reach -- ?? Index, Jan 3, 2000146911331 Realized return for 52 weeks ??17.00%20.45% Consensus (??) Expected Risk Premium for Stocks2%2% Implied volatilities -- 15 to 20% level "Normal" Stock Price Gains for 1999 -- what is "Normal"?? Qualifier: Expectations are set so that they can be easily achieved. Forecast made on December 17, 1999 for the next year S&P500DJIA Year end 2000 152512300 Index on December 15, 1999141311225 One year expected capital gains7.93%9.58% DivYld -- approx1.14%1.32% Total Expected Return9.07%10.90% 0ne year tbill yield6.11%6.11% Risk Premium2.96%4.79% Ravi Jagannathan Finance Department Kellogg Graduate School of Management Northwestern University Evanston IL 60208-2001 (847)-491-8338 (voice) (847)-491-5719 (fax) From rjaganna@nwu.edu Sat Jul 22 10:48:37 2000 Received: from lulu.it.northwestern.edu (lulu.acns.nwu.edu [129.105.16.54]) by ellen.mpls.frb.fed.us (980427.SGI.8.8.8/970903.SGI.AUTOCF) via SMTP id KAA20284 for ; Sat, 22 Jul 2000 10:48:16 -0500 (CDT) Received: (from mailnull@localhost) by lulu.it.northwestern.edu (8.8.7/8.8.7) id KAA17014 for ; Sat, 22 Jul 2000 10:47:05 -0500 (CDT) Received: from fin18338a (bp194-197.kellogg.nwu.edu [129.105.194.197]) by lulu.acns.nwu.edu via smap (V2.0) id xma016967; Sat, 22 Jul 00 10:46:15 -0500 Message-Id: <4.2.0.58.20000722104137.00d46b70@lulu.acns.nwu.edu> X-Sender: rja235@lulu.acns.nwu.edu X-Mailer: QUALCOMM Windows Eudora Pro Version 4.2.0.58 Date: Sat, 22 Jul 2000 10:46:06 -0500 To: erm (Ellen R. McGrattan) From: Ravi Jagannathan Subject: Mehra-Prescott-Dow36000 Mime-Version: 1.0 Content-Type: text/plain; charset="us-ascii"; format=flowed Status: RO Ellen-- We need to cite "DOW 36000" byJames K. Glassman and Kevin A. Hassett, The Atlantic Monthly Septmenber 1999, Here are some words on how to relate The readers may find it surprising to notice that Mehra and Prescott calculated a reasonable value for the equity premium to be less half a per year in late seventies-early eighties -- which is not very different from the 0% risk premium advocated by Glassman and Hassett in their widely publicised article, "DOW 36000". Note however that Mehra and Prescott allowed for the fact that equity investments are more risky than bond investments. --Ravi Ravi Jagannathan Finance Department Kellogg Graduate School of Management Northwestern University Evanston IL 60208-2001 (847)-491-8338 (voice) (847)-491-5719 (fax) From rjaganna@nwu.edu Sat Jul 22 19:28:31 2000 Received: from lulu.it.northwestern.edu (lulu.acns.nwu.edu [129.105.16.54]) by ellen.mpls.frb.fed.us (980427.SGI.8.8.8/970903.SGI.AUTOCF) via SMTP id TAA20693 for ; Sat, 22 Jul 2000 19:28:16 -0500 (CDT) Received: (from mailnull@localhost) by lulu.it.northwestern.edu (8.8.7/8.8.7) id TAA29232; Sat, 22 Jul 2000 19:00:26 -0500 (CDT) Received: from fin18338a (bp194-197.kellogg.nwu.edu [129.105.194.197]) by lulu.acns.nwu.edu via smap (V2.0) id xma029165; Sat, 22 Jul 00 18:59:55 -0500 Message-Id: <4.2.0.58.20000722185909.00d49e40@lulu.acns.nwu.edu> X-Sender: rja235@lulu.acns.nwu.edu X-Mailer: QUALCOMM Windows Eudora Pro Version 4.2.0.58 Date: Sat, 22 Jul 2000 18:59:46 -0500 To: a-shcherbina@nwu.edu, erm (Ellen R. McGrattan) From: Ravi Jagannathan Subject: oops!-- one more change Mime-Version: 1.0 Content-Type: text/plain; charset="us-ascii"; format=flowed Status: RO Title change: Vanishing Equity Premium: What To Expect From Stocks In The Future. "A naive investor who looks only at the past when planning for his retirement may be sadly disappointed if he forecasts future stock returns by simply extrapolating the past. This point seems to be well understood for bonds. A permanent drop in interest rates would cause bond prices to go up. Consequently the historical return on bonds would be high when at the same time future returns to holding bonds would be low. Bond investors do not use past returns to forecast the future. This point, however, seems to have been missed by many stock investors. For example it is common in finance textbooks to use the historical average return on stocks as a measure of what stocks may be expected to earn in the future. To understand the effect of declining equity premium on equity prices consider a hypothetical stock in December 1949. For expositional simplicity we will make the following assumptions. The stock paid a dividend of $1 in 1950. The dividend grew at the rate of 4% per year for sure. Risk free bonds yield stayed constant at 4% per year. Investors required an equity premium over the risk free bond rate for holding the stock even though the stock was risk free. The equity premium for 1950 was 7% and dropped to 1% for the years 2000 and after in a linear fashion. Investors fully anticipated this falling trend in the equity premium. The market price of the stock equaled its value computed using the textbook dividend discount model. Then the stock price would have been $32.40 at the end of 1949. It would have risen to $710.60 by the end of 1999. This would have given the investor a compounded annualized return of 8.4%, of which 6.4% was capital gain. If the equity premium did not change over time the stock price would have grown at the same 4% rate as the dividend. Hence we can decompose the capital gain of 6.4% into two parts: 4% that is due to the growth in dividend and 2.4% that is due to the decline in the equity premium. More than half of the historical equity premium of 4.4% per year would be due to the capital gain that came from the decline in the equity premium over time. The equity premium going forward past 1999 would only be 1% per year even though the stock earned a hefty 4.4% premium in the past. This example illustrates the findings in Fama and French (2000) who estimated that as much as forty percent of the 8.5% inflation adjusted average yearly return stocks earned over bonds during the 1950-1999 period may be due to the decline in the risk premium investors require to hold equities. To understand the level of stock prices we need to guess the equity premium going forward as well as the growth rate in future dividends. High expectations regarding the growth in future dividends as well as a lower equity premium would lead to higher stock prices. In this paper we disentangle the two effects. At the current level of stock prices, it would be prudent for investors to plan their asset allocation by assuming a substantially lower equity premium than indicated by a naive analysis of how stocks performed in the past." Ravi Jagannathan Finance Department Kellogg Graduate School of Management Northwestern University Evanston IL 60208-2001 (847)-491-8338 (voice) (847)-491-5719 (fax) From rja235@lulu.acns.nwu.edu Mon Jul 24 09:17:11 2000 Received: from res.mpls.frb.fed.us (res.mpls.frb.fed.us [192.168.1.174]) by ellen.mpls.frb.fed.us (980427.SGI.8.8.8/970903.SGI.AUTOCF) via ESMTP id JAA24249 for ; Mon, 24 Jul 2000 09:16:43 -0500 (CDT) Received: from lulu.it.northwestern.edu (lulu.acns.nwu.edu [129.105.16.54]) by res.mpls.frb.fed.us (8.8.8+Sun/8.8.8) with SMTP id JAA14722 for ; Mon, 24 Jul 2000 09:22:07 -0500 (CDT) Received: from localhost (rja235@localhost) by lulu.it.northwestern.edu (8.8.7/8.8.7) with ESMTP id JAA08187 for ; Mon, 24 Jul 2000 09:15:42 -0500 (CDT) Date: Mon, 24 Jul 2000 09:15:42 -0500 (CDT) From: Ravi Jagannathan To: erm@res Subject: Please consider adding the following two subsections Message-ID: MIME-Version: 1.0 Content-Type: TEXT/PLAIN; charset=US-ASCII Status: RO Ellen-- 1. Did investors anticipate this much decline? We may argue that investors in 1950 are unlikely to have anticipated this much decline in the risk premium. Next the question is whether it is permanent. We may take the stand that it is likely to be permanent -- does not mean that it will stay at that level ex post. It is more like a random walk (a la Hansen and Schienkman) -- even though it is a random walk it is stationary. Shiller takes the view that risk premiums will change over time and it will mean revert Dow 3600 authors take the view that it is permanent and will even decline to zero Mehra and Prescott are agnostic We may say that it is likely to stay at this level for very long and for planning purposes it is good to assume that it is what investors will get in the future. It may come down or it may go up further -- but on average planning that it will stay at this level will be good We may explain what a random walk is -- and how it will look like a trend -- it will also be mean reverting as Hansen and Scheinkman explain -- but it will still be unpredictable and hence assuming that it will stay at the current level will be prudent. 2. Fallacy of using historical avererages to predict how stocks will perform in the future. Investors who do this are likely to end up unhappy when they retire. Unfortunately even well regarded text books in finance teach this wrong way of thinking to students -- we need to highlight this -- hopefully this will catch the press. --Ravi End Year Div Prem S=d/(r-g) Ret=(P+D-P_)/P_ DiscRate-Year PVFactor-49 PV-49(D) IV-AntDecline 1949 g 14.28571429 $(32.40) $(14.29) 1950 1.00 0.04 0.07 15.11627907 0.13 0.11 0.9009 0.900900901 $32.40 $1.00 $1.00 1951 1.04 rf 0.0688 16 0.13 0.1088 0.8125 0.845000845 $1.04 $1.04 1952 1.08 0.04 0.0676 16.94072289 0.13 0.1076 0.7336 0.793428023 CapGains--prem decline anticipated $1.08 $1.08 1953 1.12 prem decline 0.0664 17.94261595 0.13 0.1064 0.6630 0.745810868 6.4% $1.12 $1.12 1954 1.17 0.0012 0.0652 19.0102016 0.12 0.1052 0.5999 0.701812616 IRR IRR-Unanticipated ep $1.17 $1.17 1955 1.22 prem start 0.064 20.14839201 0.12 0.104 0.5434 0.661127826 8.4% 12.1% $1.22 $1.22 1956 1.27 0.07 0.0628 21.36252888 0.12 0.1028 0.4927 0.62347927 $1.27 $1.27 1957 1.32 prem end 0.0616 22.65842799 0.12 0.1016 0.4473 0.588615143 Cap Gains - Unanticipated $1.32 $1.32 1958 1.37 0.01 0.0604 24.04242926 0.12 0.1004 0.4065 0.556306569 8.1% $1.37 $1.37 1959 1.42 0.0592 25.52145319 0.12 0.0992 0.3698 0.526345371 $1.42 $1.42 1960 1.48 0.058 27.10306437 0.12 0.098 0.3368 0.498542063 $1.48 $1.48 1961 1.54 0.0568 28.7955435 0.12 0.0968 0.3071 0.472724057 fration cg $1.54 $1.54 1962 1.60 0.0556 30.60796888 0.12 0.0956 0.2803 0.448734045 ant 76% $1.60 $1.60 1963 1.67 0.0544 32.55030917 0.12 0.0944 0.2561 0.426428551 unant 67% $1.67 $1.67 1964 1.73 0.0532 34.63352895 0.12 0.0932 0.2343 0.405676631 $1.73 $1.73 1965 1.80 0.052 36.86970956 0.12 0.092 0.2145 0.386358697 $1.80 $1.80 1966 1.87 0.0508 39.27218741 0.12 0.0908 0.1967 0.368365461 $1.87 $1.87 1967 1.95 0.0496 41.85571313 0.12 0.0896 0.1805 0.351596989 $1.95 $1.95 1968 2.03 0.0484 44.63663508 0.11 0.0884 0.1658 0.335961842 $2.03 $2.03 1969 2.11 0.0472 47.63311181 0.11 0.0872 0.1525 0.321376302 $2.11 $2.11 1970 2.19 0.046 50.86535868 0.11 0.086 0.1405 0.307763678 $2.19 $2.19 1971 2.28 0.0448 54.35593558 0.11 0.0848 0.1295 0.295053673 $2.28 $2.28 1972 2.37 0.0436 58.13008357 0.11 0.0836 0.1195 0.28318182 $2.37 $2.37 1973 2.46 0.0424 62.21612051 0.11 0.0824 0.1104 0.272088962 $2.46 $2.46 1974 2.56 0.0412 66.64590829 0.11 0.0812 0.1021 0.261720792 $2.56 $2.56 1975 2.67 0.04 71.45540682 0.11 0.08 0.0945 0.25202743 $2.67 $2.67 1976 2.77 0.0388 76.68533447 0.11 0.0788 0.0876 0.242963039 $2.77 $2.77 1977 2.88 0.0376 82.38195932 0.11 0.0776 0.0813 0.234485487 $2.88 $2.88 1978 3.00 0.0364 88.59805261 0.11 0.0764 0.0756 0.226556026 $3.00 $3.00 1979 3.12 0.0352 95.39404441 0.11 0.0752 0.0703 0.219139013 $3.12 $3.12 1980 3.24 0.034 102.8394332 0.11 0.074 0.0654 0.212201652 $3.24 $3.24 1981 3.37 0.0328 111.0145173 0.11 0.0728 0.0610 0.205713756 $3.37 $3.37 1982 3.51 0.0316 120.0125361 0.11 0.0716 0.0569 0.199647543 $3.51 $3.51 1983 3.65 0.0304 129.9423404 0.11 0.0704 0.0532 0.193977433 $3.65 $3.65 1984 3.79 0.0292 140.9317498 0.11 0.0692 0.0497 0.188679882 $3.79 $3.79 1985 3.95 0.028 153.1318117 0.11 0.068 0.0466 0.183733219 $3.95 $3.95 1986 4.10 0.0268 166.72226 0.12 0.0668 0.0436 0.179117499 $4.10 $4.10 1987 4.27 0.0256 181.918584 0.12 0.0656 0.0410 0.174814376 $4.27 $4.27 1988 4.44 0.0244 198.9812926 0.12 0.0644 0.0385 0.170806981 $4.44 $4.44 1989 4.62 0.0232 218.2282104 0.12 0.0632 0.0362 0.167079816 $4.62 $4.62 1990 4.80 0.022 240.0510314 0.12 0.062 0.0341 0.163618652 $4.80 $4.80 1991 4.99 0.0208 264.9379547 0.12 0.0608 0.0321 0.160410443 $4.99 $4.99 1992 5.19 0.0196 293.5051776 0.13 0.0596 0.0303 0.157443244 $5.19 $5.19 1993 5.40 0.0184 326.5415743 0.13 0.0584 0.0286 0.154706135 $5.40 $5.40 1994 5.62 0.0172 365.0734801 0.14 0.0572 0.0271 0.152189161 $5.62 $5.62 1995 5.84 0.016 410.4609938 0.14 0.056 0.0257 0.149883264 $5.84 $5.84 1996 6.07 0.0148 464.545266 0.15 0.0548 0.0243 0.147780238 $6.07 $6.07 1997 6.32 0.0136 529.8813098 0.15 0.0536 0.0231 0.145872672 $6.32 $6.32 1998 6.57 0.0124 610.1204796 0.16 0.0524 0.0219 0.144153914 $6.57 $6.57 1999 6.83 0.0112 $710.67 0.18 0.0512 $710.67 $710.67 2000 7.11 0.01 Average 12.2% Av-Prem 8.2% Reference: Summers, JF Grossman/Shiller or Shiller From rjaganna@nwu.edu Tue Aug 1 03:00:16 2000 Received: from lulu.it.northwestern.edu (lulu.acns.nwu.edu [129.105.16.54]) by ellen.mpls.frb.fed.us (980427.SGI.8.8.8/970903.SGI.AUTOCF) via SMTP id CAA08795 for ; Tue, 1 Aug 2000 02:59:57 -0500 (CDT) Received: (from mailnull@localhost) by lulu.it.northwestern.edu (8.8.7/8.8.7) id UAA27422; Mon, 31 Jul 2000 20:05:53 -0500 (CDT) Received: from fin18338a (bp194-197.kellogg.nwu.edu [129.105.194.197]) by lulu.acns.nwu.edu via smap (V2.0) id xma027333; Mon, 31 Jul 00 20:04:49 -0500 Message-Id: <4.2.0.58.20000731195001.00d509d0@lulu.acns.nwu.edu> X-Sender: rja235@lulu.acns.nwu.edu X-Mailer: QUALCOMM Windows Eudora Pro Version 4.2.0.58 Date: Mon, 31 Jul 2000 20:04:42 -0500 To: erm (Ellen R. McGrattan), erm@res From: Ravi Jagannathan Subject: please take a look Mime-Version: 1.0 Content-Type: text/plain; charset="us-ascii"; format=flowed Status: RO Ellen-- We need to differentiate the contributions of the different authors in this area -- it would be a valuable exercise. Even though I sent a copy of the Wadhwani article to Fama -- he does not seem to be inclined to give some credit to him -- we may have to do it, especially since my work with Anna was inspired by his paper. 1. Wadhwani was one of the first to use the Gordon model to infer the risk premium going forward -- we should point this out. Fama and French are followers in this respect. 2. Fama and French point out that the Gordon model estimate was lower at 3.5% as early as 1950 -- whereas the average return during the post war period is close to 8%. They point out that the higher realized return is due to in large part to the decline in the risk premium. The DOW-36000 authors argued that stock prices should be higher since the equity premium should be zero percent -- whereas it is positive. These are related points -- DOW 36000 authors went forward and Fama and French went backwards. History can not be quarreled with whereas forecasts can be questioned. It may not be inappropriate to compare and contrast Fama and French with the authors of DOW-36000. 3. What are we saying that is not in Wadhwani or Fama and French? We need to think about it. This is where I think our section about the discussion of how bond investors do not use past comes in -- we need to highlight this section. Fama and French do not make this point. Hence it is necessary to beat up on text books like Brealy and Myers. 4. We need to point out that one has to be careful in using earnings forecast -- they need to be tapered to long run growth rate in the economy -- the authors Brealey and Myers cite do not do it right (I hope) and Wadhwani does it right -- we should highlight this also. This tells us that textbook writers are not critical -- we may also say this??? 5. Our calibration exercise -- will have to be contrasted against the exercise Fama and French do - I hope there is some thing more in what we do. ---Ravi >Approved-By: approve@SSRN.COM >Date: Mon, 31 Jul 2000 12:12:46 -0500 >Reply-To: admin@SSRN.COM >Sender: "Capital Markets: Asset Pricing and Valuation Working Paper > Abstracts" >X-Phforward: V2.1@relay >From: "G. William Schwert" >Subject: FEN CapMkts-Asset WPS Vol. 3, No. 24, 07/27/2000 >To: CAPITAL-MARKETS-ASSETS-WPS@apollo.ssrn.com > >_________________________________________________________________ > > C A P I T A L M A R K E T S A B S T R A C T S: > A S S E T P R I C I N G A N D V A L U A T I O N > Working Paper Series > Vol. 3, No. 24: July 27, 2000 >_________________________________________________________________ > >Publisher: Financial Economics Network (FEN) > a division of > Social Science Electronic Publishing, Inc. (SSEP) > and Social Science Research Network (SSRN) > >Editor: G. WILLIAM SCHWERT > Distinguished University Professor of Finance and > Statistics, University of Rochester > Mailto:schwert@schwert.ssb.rochester.edu > >Copyright: SSEP, Inc. 2000. All rights reserved. > >Leading Social Science Research Delivered To Your Desktop > http://www.SSRN.Com/ > >REDISTRIBUTION > Individual and professional subscriptions to the journal are for > single users. It is a violation of copyright to redistribute > this document electronically or otherwise without the explicit > permission of Social Science Electronic Publishing, Inc. > Site licenses for organizations are available by contacting > Mailto:Site@SSRN.Com > >SIGN OFF > To stop delivery of one or more of the SSRN journals, write to > Mailto:Remove@SSRN.Com Include the JOURNAL name or the NETWORK > name or ALL in the subject line. If your address has changed, let > us know by writing to Mailto:AddressChg@SSRN.Com > >ALIGNMENT > If this document is misaligned, please set type face to a > non-proportional font such as Courier 10. > >PAPER DOWNLOADS > If you need assistance downloading papers from our web site, > please contact Mailto:Support@SSRN.Com > > >T A B L E of C O N T E N T S >_________________________________________________________________ > > >"The Equity Premium" > EUGENE F. FAMA > University of Chicago > Graduate School of Business > KENNETH R. FRENCH > Massachusetts Institute of Technology (MIT) > Sloan School of Management > > >"Have Individual Stocks Become More Volatile? An Empirical > Exploration of Idiosyncratic Risk" > JOHN Y. CAMPBELL > Harvard University > Dept. of Economics > Massachusetts Institute of Technology (MIT) > National Bureau of Economic Research (NBER) > MARTIN LETTAU > Federal Reserve Bank of New York > BURTON G. MALKIEL > Princeton University > Department of Economics > YEXIAO XU > University of Texas at Dallas > > >"What Drives Equity REIT Returns? The Relative Influences of > Bond, Stock and Real Estate Factors" > JIM CLAYTON > University of Cincinnati > Department of Finance > GREG MACKINNON > Saint Mary's University > Department of Finance and Management Science > > >"Views of Financial Economists on the Equity Premium and on > Professional Controversies" > IVO WELCH > Yale School of Management > International Center for Finance at Yale School of > Management > > >"Trading Activity and Expected Stock Returns" > TARUN CHORDIA > Owen Graduate School of Management > AVANIDHAR SUBRAHMANYAM > University of California at Los Angeles, Anderson > Graduate School of Management > RAVU V. ANSHUMAN > Indian Institute of Management > > >"Factor Models Under Firm Characteristics in Emerging Markets: A > Study of Taiwan Stock Returns" > ANLIN CHEN > National Sun Yat-sen University > EVA TU > PricewaterhouseCoopers LLP > > >"Predicting Stock Returns Using Industry-Relative Firm > Characteristics" > CLIFFORD S. ASNESS > AQR Capital Management, LLC > R. BURT PORTER > University of Florida > Department of Finance > ROSS L. STEVENS > Urbanfetch.com > > >"Factor Representing Portfolios in Large Asset Markets" > ENRIQUE SENTANA > Centro de Estudios Monetarios y Financieros (CEMFI) > > >S S R N I N F O R M A T I O N >_________________________________________________________________ > > * Administrative Information > - Missing issues & change of address > - Solicitation of abstracts > * Directors > * Advisory Board > * Subscription to SSRN Journals >_________________________________________________________________ > >ACQUIRING PAPERS > Download papers directly from the included web address or contact > the author or other contact person directly. Provide an address > to which the author or other contact person can send a paper > copy and mention that you saw the abstract in SSRN. > >EDITORIAL POLICIES > To provide the broadest coverage of research in Capital Markets: > Asset Pricing and Valuation we do not referee working papers. We > accept abstracts of working papers in Capital Markets: Asset > Pricing and Valuation whose topics suit the coverage of the > journal and which are part of the worldwide scholarly discourse. > > >W O R K I N G P A P E R A B S T R A C T S >_________________________________________________________________ > >"The Equity Premium" > > BY: EUGENE F. FAMA > University of Chicago > Graduate School of Business > KENNETH R. FRENCH > Massachusetts Institute of Technology (MIT) > Sloan School of Management > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=236590 > >Paper ID: CRSP Working Paper No. 522 > Date: July 2000 > > Contact: EUGENE F. FAMA > Email: Mailto:eugene.fama@gsb.uchicago.edu > Postal: University of Chicago > Graduate School of Business > 1101 East 58th Street > Chicago, IL 60637 USA > Phone: 773-702-7282 > Fax: 773-702-9937 > Co-Auth: KENNETH R. FRENCH > Email: Mailto:KFrench@MIT.Edu > Postal: Massachusetts Institute of Technology (MIT) > Sloan School of Management > 50 Memorial Drive > Cambridge, MA 02142 USA > >Paper Requests: > Fee for hardcopy requests: $10 first paper, $5 each additional > paper. Prepayment required. Make check payable to "CRSP", > University of Chicago, Graduate School of Business, 1101 E. 58th > Street, Chicago, IL 60637. Attention: Valerie Ruff - RO 305. > >ABSTRACT: > We compare estimates of the equity premium for 1872-1999 from > realized returns and the Gordon constant dividend growth model. > The two approaches produce similar estimates of the real equity > premium for 1872-1949, about 4.0 percent per year. For > 1950-1999, however, the Gordon estimate, 3.40 percent per year, > is only about forty percent of the estimate from realized > returns, 8.28 percent. We argue that the difference between the > realized return for 1950-1999 and the Gordon estimate of the > expected return is largely due to unexpected capital gains, the > result of a decline in discount rates. Our analysis thus > suggests that expected future stock returns are low. > > >JEL Classification: G12 >______________________________ > >"Have Individual Stocks Become More Volatile? An Empirical > Exploration of Idiosyncratic Risk" > > BY: JOHN Y. CAMPBELL > Harvard University > Dept. of Economics > Massachusetts Institute of Technology (MIT) > National Bureau of Economic Research (NBER) > MARTIN LETTAU > Federal Reserve Bank of New York > BURTON G. MALKIEL > Princeton University > Department of Economics > YEXIAO XU > University of Texas at Dallas > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=211428 > > Date: February 2000 > > Contact: MARTIN LETTAU > Email: Mailto:Martin.Lettau@ny.frb.org > Postal: Federal Reserve Bank of New York > Research Department > 33 Liberty Street > New York, NY 10045 USA > Phone: (212)720-1659 > Fax: (212)720-1773 > Co-Auth: JOHN Y. CAMPBELL > Email: Mailto:john_campbell@harvard.edu > Postal: Harvard University > Dept. of Economics > Room 213 > Littauer Center > Cambridge, MA 02138-3001 USA > Co-Auth: BURTON G. MALKIEL > Email: Mailto:bmalkiel@princeton.edu > Postal: Princeton University > Department of Economics > Princeton, NJ 08544 USA > Co-Auth: YEXIAO XU > Email: Mailto:yexiaoxu@utdallas.edu > Postal: University of Texas at Dallas > Department of Finance > 2601 North Floyd Road > Richardson, TX 75083 USA > >ABSTRACT: > This paper uses a disaggregated approach to study the volatility > of common stocks at the market, industry, and firm levels. Over > the period 1962-97 there has been a noticeable increase in > firm-level volatility relative to market volatility. > Accordingly, correlations among individual stocks and the > explanatory power of the market model for a typical stock have > declined, while the number of stocks needed to achieve a given > level of diversification has increased. All the volatility > measures move together countercyclically and help to predict GDP > growth. Market volatility tends to lead the other volatility > series. Factors that may be responsible for these findings are > suggested. > > >JEL Classification: E32, G10 >______________________________ > >"What Drives Equity REIT Returns? The Relative Influences of > Bond, Stock and Real Estate Factors" > > BY: JIM CLAYTON > University of Cincinnati > Department of Finance > GREG MACKINNON > Saint Mary's University > Department of Finance and Management Science > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=232394 > > Date: May 2000 > > Contact: JIM CLAYTON > Email: Mailto:jim.clayton@uc.edu > Postal: University of Cincinnati > Department of Finance > 402 Carl H. Lindner Hall > PO Box 210026 > Cincinnati, OH 45221-0026 USA > Co-Auth: GREG MACKINNON > Email: Mailto:greg.mackinnon@stmarys.ca > Postal: Saint Mary's University > Department of Finance and Management Science > Halifax, Nova Scotia B3H 3C3 CANADA > >ABSTRACT: > This papers offers a new approach to answering the question, > "how much of a REIT's return is driven by real estate market > influences, and how much by stock and bond factors?" > Specifically, we develop a method that allows for the > decomposition of the volatility of REIT returns into stock > market, bond market, real estate market and idiosyncratic > effects. Our results show that from 1978 to 1998, the REIT > market has gone from being driven mostly by large cap stocks to > being driven by both a small cap stock factor and a real estate > factor. There is also a steady increase over time in the > proportion of volatility not accounted for by any stock, bond or > real estate factors. The analysis indicates that some of this > this unaccounted for volatility is due to a REIT sector factor > that is common to most REITs but independent of the stock, bond > and real estate markets. Attempts to explain cross-sectional > differences in the volatility determinants for different REITs > meets with only limited success, although it seems that REITs > with larger market capitalization are more like stocks. > > >JEL Classification: G12 >______________________________ > >"Views of Financial Economists on the Equity Premium and on > Professional Controversies" > > BY: IVO WELCH > Yale School of Management > International Center for Finance at Yale School of > Management > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=171272 > > Date: December 1999 > > Contact: IVO WELCH > Email: Mailto:ivo.welch@yale.edu > Postal: Yale School of Management > P.O. Box 208200 > New Haven, CT 06520-8200 USA > >ABSTRACT: > The consensus of 226 academic financial economists forecasts an > arithmetic equity premium of 7% per year over 10 and 30 year > horizons; and 6% to 7% over 1 and 5 year horizons. Pessimistic > and optimistic 30-year scenario forecasts average 2% and 13%. > Respondents claim to revise their forecast downward when the > stock market rises. They perceive the profession's consensus to > be higher than it really is and are influenced by this > perception. There is agreement that markets are efficient and > lack arbitrage opportunities, and that government intervention > in financial markets is detrimental. > > >JEL Classification: G12 >______________________________ > >"Trading Activity and Expected Stock Returns" > > BY: TARUN CHORDIA > Owen Graduate School of Management > AVANIDHAR SUBRAHMANYAM > University of California at Los Angeles, Anderson > Graduate School of Management > RAVU V. ANSHUMAN > Indian Institute of Management > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=204488 > > Date: Undated > > Contact: TARUN CHORDIA > Email: Mailto:tarun.chordia@vanderbilt.edu > Postal: Owen Graduate School of Management > Vanderbilt University > 401 21st Avenue South > Nashville, TN 37203 USA > Phone: 615-322-3644 > Fax: 615-343-7177 > Co-Auth: AVANIDHAR SUBRAHMANYAM > Email: Mailto:asubrahm@anderson.ucla.edu > Postal: University of California at Los Angeles, Anderson Graduate > School of Management > Department of Finance > Los Angeles, CA 90095-1481 USA > Co-Auth: RAVU V. ANSHUMAN > Email: Mailto:anshuman@iimb.ernet.in > Postal: Indian Institute of Management > Department of Finance > Bannerghatta Rd. > Bangalore, Karnataka 560076 INDIA > >ABSTRACT: > Given the evidence that the level of liquidity affects asset > returns, a reasonable hypothesis is that the second moment of > liquidity should be positively related to asset returns, > provided agents care about the risk associated with fluctuations > in liquidity. Motivated by this observation, we analyze the > relation between expected equity returns and the level as well > as the volatility of trading activity (a proxy for liquidity). > We document a result contrary to our initial hypothesis, namely, > a negative and surprisingly strong cross-sectional relationship > between stock returns and the variability of dollar trading > volume and share turnover, after controlling for size, > book-to-market, momentum, and the level of dollar volume or > share turnover. This effect survives a number of robustness > checks and is statistically and economically significant. Our > analysis demonstrates the importance of trading activity-related > variables in the cross-section of expected stock returns. > > >JEL Classification: G12, G14 >______________________________ > >"Factor Models Under Firm Characteristics in Emerging Markets: A > Study of Taiwan Stock Returns" > > BY: ANLIN CHEN > National Sun Yat-sen University > EVA TU > PricewaterhouseCoopers LLP > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=213320 > > Date: February 2000 > > Contact: ANLIN CHEN > Email: Mailto:anlin@bm.nsysu.edu.tw > Postal: National Sun Yat-sen University > Department of Business Management > 70 Lien-hai Rd. > Kaohsiung 80424, TAIWAN ROC > Phone: 886-7-5252000x4656 > Fax: 886-7-5254698 > Co-Auth: EVA TU > Email: Mailto:Eva.Tu@ms6.pwcglobal.com.tw > Postal: PricewaterhouseCoopers LLP > London, UK > >ABSTRACT: > Fama and French (1993) propose a three-factor model to describe > the stock return behavior. However, it is challenged that stock > returns are determined by firm characteristics rather than > certain common factors. We are curious if a factor-based model > with more factors can mitigate the effects of firm > characteristics on stock returns. Our results show that the > factor-based models are significant but not sufficient for the > stock returns in Taiwan. Size or book-to-market ratio alone > cannot influence the stock returns under a factor-based model. > However, size along with book-to-market is significant under a > factor-based model. Furthermore, the risk characteristics are > more influential than the factor loading in the behaviors of > stock returns. We conclude that either factor-based models or > firm characteristics alone cannot fully explain the stock return > behaviors in Taiwan Stock Exchange. Employing only factor-based > model or only risk characteristics will lose some important > contents in the stock returns. > > Keywords: Stock returns, common factors, firm characteristics, > Fama-French model, momentum strategy, trading volume strategy > > >JEL Classification: G11, G12 >______________________________ > >"Predicting Stock Returns Using Industry-Relative Firm > Characteristics" > > BY: CLIFFORD S. ASNESS > AQR Capital Management, LLC > R. BURT PORTER > University of Florida > Department of Finance > ROSS L. STEVENS > Urbanfetch.com > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=213872 > > Other Electronic Document Delivery: > http://bear.cba.ufl.edu/porter/personal/research.html > SSRN only offers technical support for papers > downloaded from the SSRN Electronic Paper Collection > location. When URLs wrap, you must copy and paste > them into your browser eliminating all spaces. > > Date: February 24, 2000 > > Contact: R. BURT PORTER > Email: Mailto:porterrb@dale.cba.ufl.edu > Postal: University of Florida > Department of Finance > P.O. Box 117168 > 321 Stuzin Hall > Gainesville, FL 32611-7168 USA > Phone: 352-392-8928 > Fax: 352-392-0301 > Co-Auth: CLIFFORD S. ASNESS > Email: not available > Postal: AQR Capital Management, LLC > New York, NY USA > Co-Auth: ROSS L. STEVENS > Email: not available > Postal: Urbanfetch.com > 50 East 13th Street > New York, NY 10003 USA > >ABSTRACT: > Better proxies for the information about future returns > contained in firm characteristics such as size, book-to-market > equity, cash flow-to-price, percent change in employees, and > various past return measures are obtained by breaking these > explanatory variables into two industry-related components. The > components represent (1) the difference between firms' own > characteristics and the average characteristics of their > industries (within-industry variables), and (2) the average > characteristics of firms' industries (across-industry > variables). Each variable is reliably priced within-industry and > measuring the variables within-industry produces more precise > estimates than measuring the variables in their more common > form. Contrary to Moskowitz and Grinblatt [1999], we find that > within-industry momentum (i.e., the firm's past return less the > industry average return) has predictive power for the firm's > stock return beyond that captured by across-industry momentum. > We also document a significant short-term (one-month) industry > momentum effect which remains strongly significant when we > restrict the sample to only the most liquid firms. > > >JEL Classification: G11, G12 >______________________________ > >"Factor Representing Portfolios in Large Asset Markets" > > BY: ENRIQUE SENTANA > Centro de Estudios Monetarios y Financieros (CEMFI) > >Document: Available from the SSRN Electronic Paper Collection: > http://papers.ssrn.com/paper.taf?abstract_id=215668 > > Other Electronic Document Delivery: > ftp://ftp.cemfi.es/wp/00/0001.pdf > SSRN only offers technical support for papers > downloaded from the SSRN Electronic Paper Collection > location. When URLs wrap, you must copy and paste > them into your browser eliminating all spaces. > >Paper ID: CEMFI Working Paper No. 0001 > Date: January 2000 > > Contact: ENRIQUE SENTANA > Email: Mailto:sentana@cemfi.es > Postal: Centro de Estudios Monetarios y Financieros (CEMFI) > Casado del Alisal 5 > 28014 Madrid, SPAIN > Phone: +34 91 429 05 51 > Fax: +34 91 429 10 56 > >ABSTRACT: > We study the properties of mimicking portfolios in an > intertemporal APT model, in which the conditional mean and > covariance matrix of returns vary in an interdependent manner. > We use a signal extraction approach, and relate the efficiency > of (possibly) dynamic basis portfolios to mean square error > minimisation. We prove that many portfolios converge to the > factors as the number of assets increases, but show that the > conditional Kalman filter portfolios are the ones with both > minimum tracking error variability, and maximum correlation with > the common factors. We also show that our conclusions are > unlikely to change when using parameter estimates. > > Keywords: Factor models, basis portfolios, APT, Intertermporal > Asset Pricing, Kalman Filter > > >JEL Classification: G11 > > >P A R T N E R S in P U B L I S H I N G >_________________________________________________________________ > >Editor and Subscription Information for Journals Carrying >Accepted or Recently Published Papers Abstracted in this Issue > >Please mention SSRN when subscribing to these journals. > > >CENTER FOR RESEARCH IN SECURITY PRICES (CRSP) > Contact: Valerie Ruff > Email: Mailto:valerie.ruff@gsbpop.uchicago.edu > Postal: CRSP, Univ. of Chicago, Grad. School of Business > 1101 E. 58th Street > Chicago, IL 60637 USA > Phone: 773-702-7277 > Fax: 773-702-9937 > > URL: http://gsbwww.uchicago.edu/fac/finance/papers/ > >For more information about the CRSP working paper series, contact >addresses above. 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