Estimating exchange rate responsiveness to shocks

The goal of this paper is to examine the importance of permanent and transitory shocks using a more efficient trend-cycle decomposition of the real exchange rate series. Our main contribution is that in measuring the impact of shocks, we not only impose common trend restrictions but also common cycle restrictions. We later confirm, through a post sample forecasting exercise, the efficiency gains from imposing common cycle restrictions. Our results indicate that permanent shocks are responsible for the bulk of the real exchange rate variations for Japan, Italy, Germany, France, and the UK vis-à-vis the US dollar over short horizons. For Canada, however, transitory shocks are dominant over the short horizon. In sum, while for Japan, France, and Italy, around 15% of the variation in real exchange rate is due to transitory shocks, for Canada, Germany and the UK, over 25% of the variations over the short horizon are due to transitory shocks. Thus, we claim that the role of transitory shocks should not be ignored.     

How Taxes and Welfare Benefits Affect Work Incentives: A Life‐Cycle Perspective

Personal taxes and benefits affect the incentive to work over the life cycle by altering income–age profiles, insuring against adverse shocks and changing the returns to human capital. In this paper, we show how a life‐cycle perspective alters our impression of how the UK tax and benefit system affects women's work incentives. Given that actual longitudinal data conflate age effects, cohort effects and policy effects, and, in the UK, are not available covering the full life cycle, we use simulated data produced by a rich, dynamic structural model of female labour supply and human capital that incorporates family formation and fertility. We find that individuals experience considerable variability in work incentives across life that outweighs the variability across individuals. Changes in the presence of children and a partner, as well as the level of any partner's earnings, are key to explaining these patterns: work incentives vary dramatically depending on family composition and the earnings of any partner, especially for the lower‐skilled, and most women experience a number of different family types during the course of their lives.     

Permanent and transitory components of GDP and stock prices: further analysis

Using the conventional VAR identification approach, Cochrane (Quarterly Journal of Economics 107: 241–65, 1994) finds that substantial amounts of variation in GDP growth and stock returns are due to transitory shocks. Following the common trend decomposition of King etal. (American Economic Review 81: 819–40, 1991), we show that Cochrane's results depend on the assumption of weak exogeneity of one of the variables with respect to the cointegration vector. When this assumption holds both approaches coincide. If not, the shocks Cochrane called transitory are not totally transitory. In this case, the conventional VAR approach with the assumption of the weak exogeneity may overstate the magnitude of transitory shocks and understate that of permanent shocks. We find that the permanent components of GDP and stock prices are much larger than those estimates of Cochrane, although substantial (but much smaller than in Cochrane 1994) variations in GDP growth and stock returns are attributed to transitory shocks.     

Emerging market business cycles: Learning about the trend

Emerging market business cycles feature a higher variability of consumption relative to output and a strongly countercyclical trade balance. An equilibrium business cycle model in which agents learn to distinguish between the permanent and transitory components of total factor productivity shocks using the Kalman filter accounts for these features. Calibrated to Mexico, the model accounts for the behavior of consumption and the trade balance for a wide range of variability and persistence of permanent shocks relative to transitory shocks. Estimation for Mexico and Canada suggests more severe informational frictions in emerging markets than in developed economies.     

Information Content of Interim Earnings Components—Evidence from Finland

This study examines the information content of the interim earnings of listed Finnish firms. The degree of association between returns and interim earnings is studied. The assumption is that, compared to transitory changes, permanent changes in earnings have a greater association with returns. Unexpected returns are regressed over unexpected permanent earnings and unexpected transitory earnings. Three return measurement periods are used to examine any potential asynchrony between prices and earnings. To reduce the errors-in-variables problem expected in single-security-level studies, observations are grouped into portfolios. When the data are divided into portfolios, the results give evidence of the association as hypothesized.     

Dividend policy and permanence of earnings

We examine managers’ adjustment of dividends to information about earnings. We base our analysis on a ‘permanent earnings’ model of dividend behavior, which implies that dividends are changed primarily in response to permanent changes in earnings; transitory earnings changes have little or no effect on dividends. Within the permanent earnings framework, the permanent component of earnings may be the predominant factor affecting dividend payouts, or it may be one of the important factors affecting dividends. In the former case earnings and dividends are co-integrated; in the latter they are not. Using a sample of 337 firms over the 40 year period from 1950–1989, we find the data to be strongly consistent with the permanent earnings model. We also find that the data are more consistent with a model that relates dividend and earnings changes rather than levels. Thus, we conclude that earnings and dividends are not co-integrated. This contrasts with the implicitly co-integrated (levels) dividend model of Lintner (1956), and indicates that factors other than the permanent component of earnings, such as tax policy, clientele effects, transaction costs, etc. may have a significant impact on the long-run behavior of dividends.     

On the time series measure of conservatism: a threshold autoregressive model

In this note we propose an alternative test specification for Basu’s (1997) time series measure of conservatism that is related to the threshold unit root test of Enders and Granger (1998). We argue that a regression of changes in earnings on the lagged levels—rather than lagged changes—, including an interaction term for negative values, has three conceptual advantages compared to the conventional setup: (1) a smooth, non-oscillating impulse-response pattern to an unexpected shock in earnings (2) a more efficient estimate of persistence in the long run and (3) it can be extended to higher order autoregressive processes. We apply both approaches to a common dataset of firms from the S&P500 index. We confirm the conventional finding that negative shocks are transitory and display stronger mean reversion than positive shocks. However, while most of the literature reports mixed evidence on positive shocks, we find clear evidence that positive shocks are transitory as well. In a Monte Carlo simulation we explain this finding by documenting that larger standard errors in the Basu specification can lead to incorrect inference when the decision between persistent and transitory shocks is close.     

Consumption, the persistence of shocks, and asset price volatility

In a general equilibrium setting, a temporary component in consumption introduces a wedge between the volatility of equity returns and the volatility of consumption growth. This paper explores the asset pricing consequences of this property in a model in which consumption is the sum of a permanent and a transitory component. Permanent shocks are assumed to be rare events, while transitory shocks follow a diffusion process. When calibrated to US annual data, the model matches first and second moments of equity and bond returns for preference parameters within acceptable bounds. Permanent and transitory shocks together explain the equity premium, while transitory shocks alone explain the excess volatility of returns.     

Income Risk and Portfolio Choice: An Empirical Study

This paper investigates the relationship between portfolio choice and labor income risk in the National Longitudinal Survey of Youth 1979 Cohort. Permanent income risk (variability of shocks to income that have permanent effect) significantly reduces the share of risky assets in the household's portfolio, while transitory income risk (variability of shocks with no lasting effect) does not. This result provides strong evidence that households' portfolio choices respond to labor income risks in a manner consistent with economic theory.     

Money and economic activity,inventories and business cycles

Incomplete information is a necessary condition for any real effects produced by monetary impulses. An alternative to the local-global inference problem is explored in this paper. Agents are confronted with permanent and transitory shocks. Even with full knowledge about the stochastic structure their best perception at any particular time will usually be erroneous. Prices for each period are set at the beginning of the period on the basis of market conditions. The realization of the shock process thus creates a short-run ‘disequilibrium’ absorbed by inventory adjustments. This adjustment translates perceived transitory monetary shocks into serially correlated output movements. The analysis proceeds within the context of rational expectations It offers a generalization of equilibrium analysis in two respects. Prices are always in equilibrium relative to perceived conditions, but they do not reflect all ongoing shocks. Quantity adjustments reflect the perceived transitory shocks. The framework used involves moreover a stock-flow interaction operated by inventory adjustments. The stock-flow interaction imposes at any time a future expected adjustment path (for price-level and quantities) to the system's unique stock equilibrium. A major implication of the analysis resolves a puzzle experienced in a recent paper by Robert Hall. It reconciles intertemporal substitution with lagged effects of monetary impulses. It also reconciles small and inconclusive cyclic movements in real wages with the occurrence of production function and large variations in unemployment. Lastly, the nature of the inference problem determined by the pattern of incomplete information produces serially correlated movements conditioned on large permanent shocks.     

Permanent and Transitory Earnings,Accounting Recording Lag,and the Earnings Coefficient

In this paper, (1) wedefine precisely the terms permanent and transitory earnings;(2) we delineate the effects of the degree of permanence andof accounting recording lag on estimates of the slope coefficientfrom a returns-earnings regression and (3) we examine the relationbetween the estimates of the earnings coefficient and observablevariables that may indicate (i) the extent to which earningsare more or less permanent, and (ii) the extent to which valuerelevant events are recorded in accounting earnings in a timelyfashion. Our main point is that attributing differences in thereturns-earnings relation to one of these effects without controllingfor the other may lead to erroneous conclusions.     

Valuation Implications of Investment Opportunities and Earnings Permanence

This study investigates the value-relevance of accounting earnings in the presence of investment (growth) opportunities after making two theoretical and methodological research design refinements. First, we test for the incremental effect of growth on firms earnings response coefficients after controlling for the extent of transitory earnings under the assumption that the value-relevance of earnings with respect to growth should be stronger when earnings are more permanent. Second, we perform comprehensive factor analysis using market-based and accounting-based measures to construct a composite proxy for investment opportunities. We find that firms investment opportunities and the relative permanence of current earnings affect the value-relevance of those earnings. Additionally, we find that the interaction between permanent earnings and investment opportunities produces an even stronger price response to earnings.     

Does Consumption Respond More to Housing Wealth Than to Financial Market Wealth? If So,Why?

This paper uses long-run equilibrium relationship between consumption and different components of wealth to estimate the effect of changes in housing wealth and financial wealth on consumption. By exploiting this long-run property, it has been shown that a dollar increase in housing wealth increases consumption by seven cents, whereas, a corresponding dollar increase in financial wealth increases consumption by only three cents. This difference in the wealth effect arises because transitory shocks dominate variation in financial wealth, whereas permanent shocks account for most of the variation in housing wealth. This paper also shows that the relative importance of permanent component for housing wealth has witnessed an increase over the last thirty years. Therefore, housing wealth effect has also increased over time.     

Heterogeneous life-cycle profiles, income risk and consumption inequality

Was the increase in income inequality in the US due to permanent shocks or merely to an increase in the variance of transitory shocks? The implications for consumption and welfare depend crucially on the answer to this question. We use Consumer Expenditure Survey (CEX) repeated cross-section data on consumption and income to decompose idiosyncratic changes in income into predictable life-cycle changes, transitory and permanent shocks and estimate the contribution of each to total inequality. Our model fits the joint evolution of consumption and income inequality well and delivers two main results. First, we find that permanent changes in income explain all of the increase in inequality in the 1980s and 1990s. Second, we reconcile this finding with the fact that consumption inequality did not increase much over this period. Our results support the view that many permanent changes in income are predictable for consumers, even if they look unpredictable to the econometrician, consistent with models of heterogeneous income profiles.     

Modeling Mortality With Jumps: Applications to Mortality Securitization

In this article, we incorporate a jump process into the original Lee–Carter model, and use it to forecast mortality rates and analyze mortality securitization. We explore alternative models with transitory versus permanent jump effects and find that modeling mortality via transitory jump effects may be more appropriate in mortality securitization. We use the Swiss Re mortality bond in 2003 as an example to show how to apply our model together with the distortion measure approach to value mortality-linked securities. Pricing the Swiss Re mortality bond is challenging because the mortality index is correlated across countries and over time. Cox, Lin, and Wang (2006) employ the normalized multivariate exponential tilting to take into account correlations across countries, but the problem of correlation over time remains unsolved. We show in this article how to account for the correlations of the mortality index over time by simulating the mortality index and changing the measure on paths.     

Industry aspects of takeovers and divestitures: Evidence from the UK

This paper examines takeover and divestiture activity at the industry level for the population of UK firms over the period 1986–2000. Consistent with US research, takeovers in the UK cluster both across industries and over time. The evidence for divestitures indicates clustering across industries only. The paper further investigates whether broad and specific industry shocks (e.g., growth, free cash flow, concentration, deregulation, foreign competition, technology, stock market performance) explain takeover and divestiture clustering at the industry level. The results suggest that broad shocks increase (decrease) the likelihood of takeovers (divestitures), although not significantly for takeovers. Specific industry shocks that increase the likelihood of takeover activity include low growth, the threat of foreign competition and high stock market performance. For divestitures, high industry concentration and deregulation increase activity. Little evidence is found for deregulation as a significant factor in explaining takeover activity.     

Common and country-specific components in national stock prices

Previous studies on cointegration among national stock markets show conflicting results. This paper designs a general state space model to investigate the importance of a common world-wide component and the existence of country-specific components in national stock market indices. For G7 countries, there exist country-specific permanent and transitory components. Based on a variance decomposition analysis, Germany, Italy, and Japan's country-specific permanent shocks account for about half of their total permanent shocks. Most of France, Germany, and the United Kingdom's transitory shocks are country-specific. G7 countries do not seem to cointegrate around one common stochastic trend, and potential long-run international diversification benefits still exist.     

Stock returns,aggregate earnings surprises,and behavioral finance

We study the stock market's reaction to aggregate earnings news. Prior research shows that, for individual firms, stock prices react positively to earnings news but require several quarters to fully reflect the information in earnings. We find a substantially different pattern in aggregate data. First, returns are unrelated to past earnings, suggesting that prices neither underreact nor overreact to aggregate earnings news. Second, aggregate returns correlate negatively with concurrent earnings; over the last 30 years, for example, stock prices increased 5.7% in quarters with negative earnings growth and only 2.1% otherwise. This finding suggests that earnings and discount rates move together over time and provides new evidence that discount-rate shocks explain a significant fraction of aggregate stock returns.     

Earnings Persistence, Losses and the Estimation of Earnings Response Coefficients

One of the major themes of capital markets accounting research concerns mapping the relation between accounting earnings and security returns. There is still not agreement on the functional form of this relation. The models analysed here are those where: the level of earnings alone, the change in earnings alone, or both, scaled by price, are used as explanatory variables for returns. This article demonstrates that if earnings are either completely permanent or entirely transitory, the earnings response coefficients (ERCs) estimated by levels and changes models should coincide. However, if earnings comprise a mixed process of permanent and transitory components, the ERC estimated by the levels will differ from that estimated by the changes model. Using losses to identify transitory components in earnings, empirical evidence consistent with these predictions is provided.
A combined model using both the level of, and change in, earnings is justified as a weighted average of an earnings and a book value valuation model (e.g., Ohlson, 1989). An alternative rationalization concerns the mitigation of an errors-in-variables problem associated with the estimation of unexpected earnings (Ali and Zarowin, 1992). The results for the combined model are more consistent with the latter. In this context, some previous empirical studies perceive the levels variable as a useful addition to the changes variable when there are transitory components in earnings. However, the evidence reported here suggests that the level of earnings, scaled by price, appears to be the fundamental earnings explanatory variable for returns (Ohlson, 1991, p. 1). The changes variable can, when the errors-in-variables problem is not mitigated by other methods, be a useful addition to the levels variable.     

THE ASSOCIATION BETWEEN ANALYSTS’ FORECAST REVISIONS AND EARNINGS COMPONENTS: THE EVIDENCE OF FRS 3

This study examines whether the earnings components as required by FRS 3 help UK analysts to predict firms’ earnings changes by investigating the statistical association between analysts’ forecast revisions and firms’ unexpected earnings components. I find that analysts’ forecast revisions made in different time horizons are consistently associated with unexpected earnings components as required by FRS 3. UK analysts are able to incorporate current-year unexpected earnings components into their current and future earnings forecasts even before firms officially release this information. However, empirical results also show that current-year unexpected earnings components are not fully incorporated into analysts’ forecasts of future earnings. Analysts appear to wait for more information releases regarding firms’ future earnings and delay their revisions of future earnings forecasts. This is consistent with the evidence that the cumulative revisions of current earnings forecasts are generally associated with prior-year unexpected earnings components, and the association appears to be stronger as time progresses. Overall, this study provides evidence suggesting that the earnings components as required by FRS 3 help UK analysts to identify firms’ permanent and transitory earnings changes over different forecast horizons. This study also provides strong evidence supporting the informativeness of earnings components for analysts’ forecasts and the information set perspective of FRS 3 that highlights the importance of earnings components in predicting a reporting entity’s future performance.