Two Trees
Open Access
- 20 November 2007
- journal article
- Published by Oxford University Press (OUP) in The Review of Financial Studies
- Vol. 21 (1) , 347-385
- https://doi.org/10.1093/rfs/hhm059
Abstract
We solve a model with two i.i.d. Lucas trees. Although the corresponding one-tree model produces a constant price-dividend ratio and i.i.d. returns, the two-tree model produces interesting asset-pricing dynamics. Investors want to rebalance their portfolios after any change in value. Because the size of the trees is fixed, prices must adjust to offset this desire. As a result, expected returns, excess returns, and return volatility all vary through time. Returns display serial correlation and are predictable from price-dividend ratios. Return volatility differs from cash-flow volatility, and return shocks can occur without news about cash flows.Keywords
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