Alok Khare (PSTAT, UCSB)

Present Value Relation and the Volatility Puzzle: A Reexamination

In the seventies and eighties, martingale model for asset prices was tested using variance bounds. The publications by LeRoy and Porter, and Shiller indicated that prices violated the variance bounds implied by the model. The econometric methods of these early contributions were criticized on the grounds that tests produced biased results. Subsequent research using improved econometric methods produced similar findings. The tests are generally built on the premise that value of a firm is discounted value of dividends paid to shareholders. Miller and Modigliani show that this is true only when firms neither issue nor repurchase shares. In general, the value of a firm is the discounted present value of future net cash flows, which consists of dividends and repurchases net of share issues. We employ the variance bound test derived by West on data using this payout measure. Our result is that prices are not excessively volatile when compared to subsequent total net cash flows to shareholders. The data consist of all firms in the DJIA from 1983 to 2005.