Time-Varying Risk Premia: Cochrane’s “Discount Rates”

Must read

Elon Musk’s Twitter says it has good reason not to pay for $200,000 private jet trip: The company overbilled us

Twitter Inc. fired back at a private jet provider that sued over unpaid bills, saying the company overcharged for the social media giant’s head...

Elon Musk’s false ‘funding secured’ tweet caused Tesla investors ‘consequential harm’ to the tune of $12 billion, jury told

Tesla investors lost $12 billion over 10 days as a result of Elon Musk’s famous tweet in 2018 that he had “funding secured” to...

Governments need to work with the private sector to solve their trust crisis

Democracies everywhere are experiencing a trust crisis. Polling by the global public relations firm Edelman shows that from 2021 to 2023...

Air travelers would get $1,350 if bumped under proposed ‘passenger bill of rights’ that comes just weeks after Southwest Airlines’ epic meltdown

Senators who want to impose tougher penalties when U.S. airlines strand or delay passengers say they finally might be able to turn their ideas...

“Asset prices should equal expected discounted cashflows. Forty years ago, Eugene Fama (1970) argued that the expected part, ‘testing market efficiency,’ provided the framework for organizing asset-pricing research in that era. I argue that the ‘discounted’ part better organizes our research today.

“I start with facts: how discount rates vary over time and across assets. I turn to theory: why discount rates vary.” — John H. Cochrane, Senior Fellow, Hoover Institution, Stanford University

In his 2011 Presidential Address to the American Finance Association, John H. Cochrane explores time-varying expected returns. As David DeRosa writes in Bursting the Bubble: Rationality in a Seemingly Irrational Market, Cochrane “seeks to explain subsequent long-term returns on common stocks with current dividend yields.”

In times of depressed yields or high valuation ratios, Cochrane’s full address is well worth revisiting.

Subscribe Button

So, what is his underlying thesis?

Cochrane posits a pattern of predictability across markets that a yield or valuation ratio directly transforms to expected excess returns for all asset classes and features both a strong common element and a strong business cycle component.

Though his presentation is titled “Discount Rates,” he observes that “discount rate,” “risk premium,” and “expected return” are all really the same thing. Cochrane asserts that discount rates vary over time and supports his point by modeling common equity returns with current dividend yields in a regression, similar to the Shiller regression.

He analyzes the annual data as well as the five-year holding periods, and while the R2 of the regression is not especially robust, the regression coefficient is actually quite large. This indicates that returns vary considerably with the dividend yield. Cochrane asks the question, “How much do expected returns vary over time?”

Moreover, the R2 rises with time. Why? Cochrane explains that “High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high returns.”

Tile for Puzzles of Inflation, Money, and Debt: Applying the Fiscal Theory of the Price Level

This predictable pattern holds across all markets, according to his analysis. A yield or valuation ratio transforms one-for-one to expected excess returns for equities, bonds, credit markets, FX, sovereign debt, and houses. Cochrane describes this as follows:

  • With housing, higher price/rent ratios do not anticipate perennially higher prices or increasing rents but simply low returns.

“There is a strong common element and a strong business cycle association to all these forecasts,” Cochrane explains. “Low prices and high expected returns hold in ‘bad times,’ when consumption, output, and investment are low, unemployment is high, and businesses are failing, and vice versa.”

Ad for Bursting the Bubble

What’s the big lesson investors can cull from these findings? My answer is that Cochrane’s research on time-varying expected returns is essential. In practice, we can incorporate Cochrane’s insights into our applied asset-pricing models.

And in today’s “seemingly irrational” markets, we can also maintain a sense of humility. As Cochrane observes:

“Discount rates vary a lot more than we thought. Most of the puzzles and anomalies that we face amount to discount-rate variation we do not understand.”

For more insights on Cochrane’s scholarship, among other topics, don’t miss “Cochrane and Coleman: The Fiscal Theory of the Price Level and Inflation Episodes” and Bursting the Bubble: Rationality in a Seemingly Irrational Market, from the CFA Institute Research Foundation.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Anthony Harvie


Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.

Sebastian Petric, CFA

Sebastian Petric, CFA, is an investment professional with LGT and worked previously as a capital market researcher with Raiffeisen Bank International and as a director in the investment office of UBS. He was educated at the Vienna University of Economics and Business, the London School of Economics, and the University of Oxford. Petric has a strong interest in asset pricing, development finance, inclusive globalization, and sustainable economic growth and recently published his book, entitled Predictability of Financial Crises: The Impact of Fundamental, Policy-induced and Institutional Vulnerabilities on China Compared to other Emerging Markets.

More articles

Latest article

Elon Musk’s Twitter says it has good reason not to pay for $200,000 private jet trip: The company overbilled us

Twitter Inc. fired back at a private jet provider that sued over unpaid bills, saying the company overcharged for the social media giant’s head...

Elon Musk’s false ‘funding secured’ tweet caused Tesla investors ‘consequential harm’ to the tune of $12 billion, jury told

Tesla investors lost $12 billion over 10 days as a result of Elon Musk’s famous tweet in 2018 that he had “funding secured” to...

Governments need to work with the private sector to solve their trust crisis

Democracies everywhere are experiencing a trust crisis. Polling by the global public relations firm Edelman shows that from 2021 to 2023...

Air travelers would get $1,350 if bumped under proposed ‘passenger bill of rights’ that comes just weeks after Southwest Airlines’ epic meltdown

Senators who want to impose tougher penalties when U.S. airlines strand or delay passengers say they finally might be able to turn their ideas...

How the airline industry is using A.I. to improve the entire experience of flying

When Swiss International Air Lines began to use A.I. technology to boost efficiency, the carrier was able to better optimize more than half the...