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RFS Advance Access published online on November 20, 2007
Review of Financial Studies, doi:10.1093/rfs/hhm059
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© 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

Two Trees

John H. Cochrane*
University of Chicago

Francis A. Longstaff**
The UCLA Anderson School and NBER

Pedro Santa-Clara**
The UCLA Anderson School and NBER

Address correspondence to Francis Longstaff, UCLA/Anderson School, 110 Westwood Plaza, Los Angeles, CA 90095-1481; United States or email: francis.longstaff{at}anderson.ucla.edu.


  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.

* Graduate School of Business, University of Chicago, and NBER.

** The UCLA Anderson School and NBER.

John Cochrane gratefully acknowledges research support from an NSF grant administered by the NBER and from the CRSP. The authors are grateful for the comments and suggestions of Chris Adcock, Yacine Aï; t-Sahalia, Andrew Ang, Ravi Bansal, Geert Bekaert, Peter Bossaerts, Michael Brandt, George Constantinides, Vito Gala, Mark Grinblatt, Lars Peter Hansen, John Heaton, Jun Liu, Ian Martin, Anna Pavlova, Monika Piazzesi, Rene Stulz, Raman Uppal, Pietro Veronesi, anonymous referees, and many seminar and conference participants. We are also grateful to Bruno Miranda for research assistance.


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