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Moment Matching in the Present Value identity, and a New Model

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  • Dooruj McRambaccussing

Abstract

The constrained Vector Autoregression and the fairly recent state space approach are commonly used in the asset pricing literature to estimate present value models. They are used to model time series dynamics of discount rates and expected dividend growth, with the objective of understanding predictability and stock market movements. This paper shows that an ARMA(1,1) structure of price-dividend ratio and realized dividend growth nests an AR(1) speci cation for expected returns and expected dividend growth. A simpler model is proposed which involves estimating realized dividend growth and the price-dividend ratio as an ARMA(1,1), and matching the variance and autocorrelation of the estimated models to those of the present value to estimate parameters. Monte Carlo results show that the state space model has larger standard errors. Expected returns is persistent in both models, unlike expected dividend growth in the ARMA(1,1). A modest application of the model to the predictability literature shows stronger evidence towards dividend growth predictability.

Suggested Citation

  • Dooruj McRambaccussing, 2015. "Moment Matching in the Present Value identity, and a New Model," Dundee Discussion Papers in Economics 291, Economic Studies, University of Dundee.
    • Handle: RePEc:dun:dpaper:291
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    File URL: http://www.dundee.ac.uk/media/dundeewebsite/economicstudies/documents/discussion/DDPE_291.pdf
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    References listed on IDEAS

    as
    1. Tuomo Vuolteenaho, 2002. "What Drives Firm‐Level Stock Returns?," Journal of Finance, American Finance Association, vol. 57(1), pages 233-264, February.
    2. Dooruj Rambaccussing, 2015. "Modelling Housing Prices using a Present Value State Space Model," Dundee Discussion Papers in Economics 285, Economic Studies, University of Dundee.
    3. Golinski, Adam & Madeira, Joao & Rambaccussing, Dooruj, 2014. "Fractional Integration of the Price-Dividend Ratio in a Present-Value Model of Stock Prices," SIRE Discussion Papers 2015-79, Scottish Institute for Research in Economics (SIRE).
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    5. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," The Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    6. Rambaccussing, Dooruj, 2015. "Modelling Housing Prices using a Present Value State Space Model," 2007 Annual Meeting, July 29-August 1, 2007, Portland, Oregon TN 2015-32, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    7. Engsted, Tom & Pedersen, Thomas Q. & Tanggaard, Carsten, 2012. "Pitfalls in VAR based return decompositions: A clarification," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1255-1265.
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    More about this item

    Keywords

    Present Value; VAR; State Space; Moment Matching;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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