The Conditional Relationship between the Equity Risk Premium and the Dividend Price Ratio
58 Pages Posted: 5 Apr 2003
Date Written: April 2003
Abstract
The dividend price ratio is among the most commonly proposed instruments for forecasting equity returns. Despite an ongoing debate struggling to establish the efficacy of regressions using the dividend price ratio to measure the conditional equity premium, such affine functions are now pervasive in literatures that use the conditional equity premium as an input. In this paper, I point out that economic models of risk speak directly to the properties of predictability regression statistics. Specifically, I demonstrate that in reasonable theoretical settings, predictability regressions may be badly misspecified. In particular, they may have low power to identify the conditional and nonlinear form of predictability suggested by structural treatments of risk. Additionally, simple predictive regressions produce estimates of the conditional risk premium which may be very different from the true values. Moreover, accommodating the implied instability in the relationship between the dividend price ratio and the equity risk premium can substantially improve out of sample forecasting power.
Keywords: stock return, predictability, dividend yield, dividend price ratio
JEL Classification: G12, G14
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Consumption, Aggregate Wealth and Expected Stock Returns
By Martin Lettau and Sydney C. Ludvigson
-
Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles
By Ravi Bansal and Amir Yaron
-
Dividend Yields and Expected Stock Returns: Alternative Procedures for Interference and Measurement
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia are Time-Varying
By Martin Lettau and Sydney C. Ludvigson
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia Wre Time-Varying
By Martin Lettau and Sydney C. Ludvigson