Working Paper: CEPR ID: DP14107
Authors: Davide Delle Monache; Ivan Petrella; Fabrizio Venditti
Abstract: In this paper we develop a general framework to analyze state space models with time-varying system matrices, where time variation is driven by the score of the conditional likelihood. We derive a new filter that allows for the simultaneous estimation of the state vector and of the time-varying matrices. We use this method to study the time-varying relationship between the price dividend ratio, expected stock returns and expected dividend growth in the US since 1880. We find a significant increase in the long-run equilibrium value of the price dividend ratio over time, associated with a fall in the long-run expected rate of return on stocks. The latter can be attributed mainly to a decrease in the natural rate of interest, as the long-run risk premium has only slightly fallen.
Keywords: State space models; Time-varying parameters; Score-driven models; Equity premium; Present-value models
JEL Codes: C32; C51; C53; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| price-dividend ratio (G35) | expected stock returns (G17) |
| natural rate of interest (E43) | expected stock returns (G17) |
| price-dividend ratio (G35) | long-run expected rate of return on stocks (G17) |
| long-run expected rate of return on stocks (G17) | long-run risk premium (G19) |
| expected returns (G17) | expected dividend growth (G35) |
| expected stock returns (G17) | long-run expected excess return (D84) |