Asset-Pricing Implications of Dividend Volatility

Abstract

This paper establishes dividend volatility as a fundamental risk metric that prices assets. We theoretically incorporate dividend volatility clustering into a model in which narrow-framing investors are loss averse over fluctuations in the value of their investments. Our model shows that dividend volatility positively predicts future asset returns, with the predictive power increasing with the forecasting horizon; our model also sheds light on a variety of other asset-pricing phenomena. We further provide supporting empirical evidence that dividend volatility is indeed priced in the data. More specifically, aggregate dividend volatility predicts and is predicted by aggregate price-to-dividend ratios; aggregate dividend volatility predicts future aggregate market returns; and dividend volatility of portfolios sorted by size, book-to-market ratios, and past returns predicts future portfolio-level returns, respectively. This paper was accepted by Wei Xiong, finance.