Two Trees

John Cochrane, Francis Longstaff and Pedro Santa-Clara

The Review of Financial Studies, 2008, vol. 21, issue 1, 347-385

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. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Date: 2008
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