Asset Pricing

Zheng Zhenlong

Price change: cash flow or discount rate?

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Asset Pricing

Zheng ZhenlongWhy do prices vary so much?

Asset Pricing

Zheng Zhenlong

Asset Pricing

Zheng ZhenlongIntroduction

• 1970s view:Expected returns don’t move much over

time — stocks are unpredictable.Prices move on news of cashflow

(dividend).CAPM works pretty well.Beta derives from the covariance of

cashflows with market cashflows.

05:48

Asset Pricing

Zheng ZhenlongIntroduction

• All are dramatically different now.1. Expected returns move a lot over time — stocks are predictable. (Long run, business cycle correlation)2. Prices move on news of discount rate changes.3. We understand the cross-section with multifactor models.

(a) A larger number of characteristics other than beta are associated with expected returns(b) To the extent we understand those patterns, expected returns line up with nonmarket betas

Asset Pricing

Zheng ZhenlongIntroduction

4. Betas derive from the covariance of discount rates with market discount rates. 5. Facts are pushing us to the “risk premium” view of the world, as opposed to the “constant expected return, cashflow” view from the 1970s. 6. These are the facts underlying theoretical modeling.

Asset Pricing

Zheng ZhenlongOld Facts

Asset Pricing

Zheng ZhenlongNew View of facts

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Zheng Zhenlong

Why D/P forecasts long horizon returns?

Asset Pricing

Zheng Zhenlong

Predictability of Dividend growth

• P/D “should” forecast a dividend rise. Price high relative to current dividends should mean that future dividends will be higher.

• Dividend growth is not predictable! The point estimates are the “wrong” sign!

Asset Pricing

Zheng Zhenlong

Do “low” prices mean / reveal high returns?

Asset Pricing

Zheng Zhenlong

“Predictability” ↔ time-varying expected returns

Asset Pricing

Zheng ZhenlongInefficiency?

• Does this mean markets are “inefficient”? Is this an invitation to “buy low and sell high?”

• Not necessarily. Time varying risk premia are possible.

• Are expected returns higher in good times or in bad times? (Bad, why?) business-cycle related time-varying risk premium is certainly possible.

Asset Pricing

Zheng Zhenlong

Campbell-Shiller linearization of the one-period return

• 小写字母代表大写字母的对数• Intuition: higher returns come from higher prices

(higher valuations p-d), lower initial prices, or higher dividends.

Asset Pricing

Zheng Zhenlong

The Campbell-Shiller present value identity

• If both Δd and r are unforecastable, p−d is constant. If p-d varies at all, something must be forecastable. The fact that d-p varies means that we do not live in an iid world. (Plus no bubbles)

Asset Pricing

Zheng Zhenlong

Asset Pricing

Zheng ZhenlongA Pervasive Phenomenon

• Stocks. Dividend yields forecast returns, not dividend growth.

• Treasuries. A rising yield curve signals better 1-year returns for long-term bonds, not higher future interest rates. Fed fund futures signal returns, not changes in the funds rate.

• Bonds. Much variation in credit spreads over time and across firms or categories signals returns, not default probabilities.

• Foreign exchange. International interest rate spreads signal returns, not exchange rate depreciation.

• Houses. High price/rent ratios signal low returns, not rising rents or prices that rise forever.

Asset Pricing

Zheng Zhenlong

Asset Pricing

Zheng Zhenlong

Common element: business cycle

• low prices, high returns in recessions. High prices, low returns in booms

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Zheng Zhenlong

Multivariate Challenges: More variables

Asset Pricing

Zheng Zhenlong

Understanding prices: short and long-run forecasts

• Cay:消费财富比率

Asset Pricing

Zheng ZhenlongThe cross section

5

Asset Pricing

Zheng ZhenlongValue effect and factor

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Zheng Zhenlong

Value (size, and bond factors)

Asset Pricing

Zheng Zhenlong

The Multidimensional Challenge

(Market, value, size), momentum, accruals, equity issues, beta-arbitrage, credit risk, bond & equity market timing, carry trade, put writing, “liquidity provision,”...1. Which of these are independently important for E(Re )?(“multiple regression”)2. Does E(Re ) spread correspond to new factors?3. Do we need all the new factors? Or again, fewer factors thanE(Re ) characteristics?4. Why do prices move? –Long run.

How to approach such a highly multidimensional problem?

Asset Pricing

Zheng Zhenlong

Asset Pricing on Characteristics/Uni…cation

1. Portfolio sorts are really cross-sectional regressions

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Zheng Zhenlong

Asset Pricing on Characteristics/Uni…cation

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Zheng Zhenlong

Theory classifi…cation

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Zheng ZhenlongConsumption/habits

Asset Pricing

Zheng ZhenlongInvestment and Q

Asset Pricing

Zheng ZhenlongChallenges for theories

Pervasive, coordinated risk premium in all markets, especially unintermediated

Mean returns are associated with comovement. Strong correlation with macroeconomics

Asset Pricing

Zheng Zhenlong“Arbitrages”

Asset Pricing

Zheng Zhenlong“Arbitrages”

Asset Pricing

Zheng Zhenlong

Price and volume in the tech “bubble

Asset Pricing

Zheng ZhenlongBonds ： a cautionary tale�

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Zheng Zhenlong

Stocks (your endowment) in the crisis

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Zheng Zhenlong

Alphas, betas, and performance evaluation

• A hedge fund manager said, “‘Exotic beta’ is my alpha. I understand those systematic factors and know how to trade them. My clients don’t.”

Asset Pricing

Zheng ZhenlongConclusion

Discount rates vary over time and across assets a lot more than you thought

Empirical: how. Theoretical: why. Applications: at all.

We’ve only started� How do you ask the right question?

Asset Pricing

Zheng Zhenlong