Selected Journal Publications

11.10.2019

Equity Cash Flows and Expected Returns

News Shocks and the Production-Based Term Structure of Equity Returns
AI, Hengjie | CROCE, Mariano Max | DIERCKS, Anthony M. | LI, Kai
The Review of Financial Studies, Volume 31, Issue 7, 2423–2467

The connection between the timing of equity cash flows and expected returns has been the subject of much research in recent years. A number of stylized facts on the term structure of equity returns—the relationship between the return on claims to aggregate dividend strips and their maturity—have been well-documented.

First, the slope of the term structure varies substantially over time and is significantly negative in the Great Recession. Second, the returns on short-term dividend claims have higher volatility but lower market beta than an index on aggregate dividends. Third, the capital asset pricing model betas of claims to aggregate dividends are countercyclical, and this time variation of betas decreases with maturity.

In response, Ai, Croce, Diercks, and Li proposed a novel production-based model to provide a unified explanation of the stylized features of the slope of the term structure of equity returns, its variations over the business cycle, and the negative relationship between cash-flow duration and expected returns in the cross-section of book-to-market-sorted portfolios.

Incorporating long-run growth news with time-varying volatility and slow learning about the exposure that firms have with respect to these news shocks, their model shows that investment responds strongly and positively to contemporaneous productivity shocks. This is also found in the existing data. However, its reaction to news about future productivity shocks is negative upon impact. As a result, the total payout to the household increases upon the arrival of good long-run news. Therefore, the impulse response to contemporaneous productivity leads to an upward-sloping term structure of dividends, while the response of investment to news shocks provides a mechanism for a higher risk premium for short-term dividend strips that is absent in a large number of neoclassical growth models.

The authors also provide a novel empirical analysis linking news shocks, time variation in long-run news uncertainty, aggregate payouts, and equity term structure slope. They demonstrate that the volatility of the persistent component of productivity shocks exhibits substantial variation over time, and peaks during recessions. When incorporated into their model, the productivity-based volatility factors produce a procyclical term structure slope which turns negative during severe recessions. Again, this is consistent with the data.

The key mechanism in their study is based on the interplay of learning about exposure to aggregate shocks and the time-varying volatility of news regarding future productivity shocks. They show that their model is able to explain the stylized facts about the time-varying slope of the term structure of dividend strips, as well as the negative relationship between cash-flow duration and expected returns in the cross-section of equity returns.

Although a fully specified, general equilibrium model with endogenous capital structure choices was beyond the scope of their study, the authors see it as an important area of future research. They also hope that using their model, subsequent studies will be able to analyse the term structure of equity from a multi-country point of view, thereby shedding light on international co-movements.


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