Cash Flow Channel Research Articles

Instability of discount-rate and cash-flow channels of stock returns: a nonparametric approach

ABSTRACT According to the log-linear return approximation, the ability of a predictor to predict future stock returns may arise from its ability to predict either the cash flows or the discount rates, or both. This paper introduces a novel nonparametric approach to investigating the time variability in the predictability channels of the equity premium within a present-value framework. Using the existing return predictors, including the measures of economic uncertainty and sentiment, we document strong time variation in both discount-rate and cash-flow channels. In comparison, the predictability of the equity premium through the cash-flow channel is more pronounced than through the discount-rate channel.

Innovation Under Pressure

Abstract Firms become more efficient at innovation activities when they face pressure to meet earnings per share (EPS) targets using stock repurchases. Using a regression-discontinuity framework, we find that incentives to engage in “EPS-motivated buybacks” are followed by more citations and higher values for firms’ new patents. We trace these effects to improved allocation of R&D resources and a greater focus on novel innovation. The positive effects are concentrated among ex ante “innovation-efficient” firms that achieve better patenting outcomes after reorganizing (but not cutting) their R&D investments. Our findings illustrate that short-term earnings pressure can act through a free cash flow channel that motivates more efficient spending.

Forecasting stock market returns with a lottery index: Evidence from China

AbstractThis study constructs a Chinese lottery index (LI) based on six popular lottery preference variables by using the partial least squares method and examines the relationship between the LI and future stock market returns during the period from January 2000 to December 2021. We find that the LI can negatively predict stock market excess returns in‐sample and out‐of‐sample. In addition, the LI can generate a large economic gain for a mean–variance investor. Finally, the predictive sources of the LI stem from a cash flow channel and can be explained by the positive volume–volatility relationship and investor attention.

Trademarks and the cost of equity capital

Employing a sample of 4655 U.S. public firms from 1993 to 2017, we document robust evidence that firms with more registered trademarks have a lower cost of equity. We further show that the equity financing cost is lower for firms with better-protected trademarks in difference-in-differences estimation based on the enactment of the Federal Trademark Dilution Act in 1996. In addition, our analysis reveals that the effect of trademarks on the cost of equity is achieved through the informational channel, the disciplinary channel, and the stabilizing cash flow channel. These results suggest that trademarks play an important role in alleviating the equity financing cost, thus clarifying the underlying mechanism that brand equity creates value.

Cost stickiness and firm value

In this paper we explore the association between cost stickiness and firm value. Using a large sample of U.S. data, we find a robust negative relationship between cost stickiness and firm value. We then explore whether the resource adjustment, managerial expectations, and agency theories of cost stickiness affect the negative relation and find support for the managerial expectation and agency theories. Furthermore, we find evidence that the detrimental impact of cost stickiness on firm value is mediated partially through the cost of equity and cash flow channels. Further investigation suggests that the adverse effects of cost stickiness on firm value is stronger in the presence of high information asymmetry. We enrich the cost management literature by integrating cost stickiness with corporate finance.

Household net saving positions and unconventional monetary policy transmission: Evidence from Japan

This paper investigates the heterogeneous effect of unconventional monetary policy (UMP) on household consumption across different household net saving positions. Using Japanese household survey data on household balance sheet positions, income, and expenditures, we enhance the role of the cash-flow channel in the UMP transmission. Households in a lower net saving position (with a higher level of debt) exhibit significantly positive expenditure responses to expansionary UMP shocks. In contrast, households in an upper net saving position (with a lower level of debt) respond little. We also find that households in lower net saving positions primarily drive the aggregate effects of UMP on household consumption.

The impact of opacity on bank valuation during the global financial crisis: A channel analysis

Prior literature suggests that opacity in the banking industry is mainly caused by a lack of informativeness in the assessment of the quality of bank assets. Examining a sample of bank holding companies in the United States, we find that there is a negative relationship between opacity and bank valuation during the 2007–2009 global financial crisis. We further attempt to identify two potential channels through which opacity negatively affects bank valuation during the financial crisis: a cash flow channel and an expected return channel. We show that one channel flows from bank profitability, measured by return on equity and return on assets, confirming a cash flow channel, whereas an expected return channel, proxied by the implied cost of capital, only works for small banks. Overall, this study sheds light on the relationship between in-transparency and bank value discount during a global recession.

Spillback effects of US unconventional monetary policy

This study examines the spillback effects of US forward guidance (FG) and large-scale asset purchases (LSAPs) policies based on a proxy structural vector autoregression model and structural scenario analysis. We use high-frequency asset price surprises to identify FG and LSAP shocks. We find that both FG and LSAP shocks have significant spillback effects on economic activity and inflation in the US. Geographically, spillbacks of US unconventional monetary policies materialize more for advanced economies than emerging market economies. In addition, we find that spillbacks materialize through the exchange rate channel, the Tobin’s q channel, and the cash flow channel.

Nonparametric Estimation and Testing for Instability of Discount Rate and Cash Flow Channels of Stock Returns

Nonparametric Estimation and Testing for Instability of Discount Rate and Cash Flow Channels of Stock Returns

Anger in predicting the index futures returns

AbstractThis paper aims to investigate how different emotions affect the subsequent index futures returns. We test the forecasting regressions which predict the S&P 500 index futures returns with lagged text‐based emotion (anger, joy, fear, optimism, and gloom) indices and find asymmetric forecasting power exists between pessimism and optimism emotion indices. We show that only the text‐based anger index could reliably perform at predicting index futures return in‐sample and outperform the prevailing unconditional mean out‐of‐sample. Notably, the predictive power of the text‐based anger index persists after controlling for other emotion indices, investor sentiment indices, and fundamental variables known to predict the futures market. And the asset allocation conditioning on text‐based anger index can generate substantial economic benefits. Furthermore, the anger index influences the index futures return through both the discount rate and cash flow channels.

The RP-PCA factors and stock return predictability: An aligned approach

Our study first investigates robust evidence for the predictive power of risk premium principal component analysis (RP-PCA) in forecasting equity returns and macroeconomic activity. We use the partial least squares (PLS) method to extract the optimal information from five RP-PCA factors, and the aligned RP-PCA index appears to outperform the original RP-PCA factors in various in-sample and out-of-sample diagnostic tests with little evidence of instability. Furthermore, the aligned RP-PCA index can generate adequately more profits than most of the other RP-PCA factors in an active market-timing trading strategy in excess of the historical mean forecast strategy. A vector autoregression-based stock return decomposition shows that the economic source of the forecasting power for the aligned RP-PCA index predominantly comes from the future cash flow channel.

Real estate climate index and aggregate stock returns: Evidence from China

We show that China's real estate climate index (RECI) can be used to forecast the aggregate stock market return. It outperforms popular return predictors both in- and out-of-sample, especially at the monthly horizon. Additionally, RECI's predictive ability is stronger among stocks of small market capitalization and low momentum. For a typical mean-variance investor, RECI's predictive power may provide an additional utility gain of 3.41%. We discuss three potential sources of RECI's predictive ability and present the corresponding evidence, including the cash flow channel, the firm fundamental channel, and the investment substitution channel.

Mortgage cash-flows and employment

This paper quantifies the impact of the cash-flow channel of monetary policy on employment by combining novel micro datasets with near-universal coverage. When interest rates fall, mortgaged households spend an important share of the extra cash-flow in their local economy, increasing local labor demand. Overall, a reduction in mortgage payments of £1,000 per household leads to a 0.5 percentage point increase in locally non-tradable employment growth over three years, almost entirely driven by the restaurant sector. Employment-growth effects operate through the intensive margin for small establishments, lower death rates for the mid-sized and higher birth rates for the largest outlets.

Terrorism and international stock returns

We develop a terrorism risk factor and show its statistical and economic relevance to stock returns. Using time-series data from 40 stock markets around the world, we show that our terrorism factor has a statistically strong contemporaneous effect on countries’ stock returns and is able to predict returns for approximately 53% of the countries in our sample. Our findings suggest that the source of this predictability is via both the discount rate and cash flow channels. Our results survive a battery of robustness tests, including tests based on multiple proxies for the terrorism factor.

EVALUATION OF MONETARY POLICY IN EMU THROUGH CREDIT CHANNELS INTERCONNECTEDNESS: EVIDENCE USING BLS DATA

Credit channel(s) of the monetary policy transmission has not been debated much in the literature especially in the context of the European monetary union (EMU) and the apparent rising fragmentation of the previously much integrated European banking system. This discussion is even more important in the aftermath of the global financial crisis (GFC) and the decade-long European debt crisis (EDC), a number of European countries have been experiencing. This paper attempts to investigate the interconnectedness of credit channels in policy transmission in the context of EMU using bank lending survey (BLS) data for a sample of eight European countries. One of the main contributions of this paper is to use BLS data for the entire 11 credit channels. We use principal component analysis (PCA) to investigate the impact of monetary policy on the interconnectedness structure of credit channels. PCA is conducted both for EMU across channels and sample countries. EFA-orthogonal vector rotation indicates a core versus periphery interconnectedness pattern. The results suggest that the household balance sheet channel, borrower cash flow channel and interest rate channel are the most divergent channels in EMU.

Are disagreements agreeable? Evidence from information aggregation

Disagreement measures are known to predict cross-sectional stock returns but fail to predict market returns. This paper proposes a partial least squares disagreement index by aggregating information across individual disagreement measures and shows that this index significantly predicts market returns both in- and out-of-sample. Consistent with the theory in Atmaz and Basak (2018), the disagreement index asymmetrically predicts market returns with greater power in high-sentiment periods, is positively associated with investor expectations of market returns, predicts market returns through a cash flow channel, and can explain the positive volume-volatility relationship.

Cross-Sectional Uncertainty and Aggregate Stock Returns

We study the predictability of cross-sectional uncertainty (CSU) proposed by Dew-Becker and Giglio (2021) for stock returns. We find that CSU exhibits significant power for predicting monthly stock returns with annual out-of-sample R^2 of 6.34%, greater than popular predictors. CSU generates significant economic gains for a mean-variance investor with annualized utility gain of 7.92% and a Sharpe ratio of 1.19. The predictability of CSU is better in good than bad times, and a bivariate combination forecast using CSU with one of Goyal and Welch (2008) variables produces annual out-of-sample R^2 ranging from 16.22% to 42.88%. A vector autoregression decomposition shows that the source of predictability mainly comes from a cash flow channel.

The Marginal Profit-to-Q Ratio: Reassessing the Cash-Flow Channel

We study a production-based present-value relation that implies that fluctuations in the marginal profit-to-marginal Q ratio (mq) are driven by variations in the expected growth of marginal profits (cash-flow channel), expected investment return changes (discount-rate channel), or both. We find that in contrast to the aggregate dividend-to-price ratio, mq strongly predicts marginal profits growth at both short and long horizons, but not investment returns. mq also predicts (negatively) the growth rates of aggregate earnings, industrial production, and non-farm payrolls. Our findings can guide modeling in which the expected growth rate of marginal profits (at multiple horizons) is time-varying.

Inferring Stock Duration Around FOMC Surprises: Estimates and Implications

AbstractDiscount rates affect stock prices directly via the discount-rate channel or indirectly via the cash-flow channel because expected future cash-flow growth varies with the discount rate. The traditional Macaulay duration captures the effect from the discount-rate channel. I propose a novel duration measure, the effective equity duration, to capture the effects from both channels. I estimate it around unexpected policies in the federal funds rates. I find that the equity yield curve is hump-shaped because expected future cash-flow growth increases with the discount rate. The effective equity duration captures information other than monetary policy risk.

Household Debt and Monetary Policy: Revealing the Cash-Flow Channel

AbstractWe examine the effect of monetary policy on household spending when households are indebted and interest rates on outstanding loans are linked to short-term interest rates. Using administrative data on balance sheets and consumption expenditure of Swedish households, we reveal the cash-flow transmission channel of monetary policy. On average, indebted households reduce consumption spending by an additional 0.23–0.55 percentage points in response to a one-percentage-point increase in the policy rate, relative to a household with no debt. We show that these responses are driven by households that have some or a large share of their debt in contracts where interest rates vary with short-term interest rates, such as adjustable-rate mortgages (ARMs), which implies that monetary policy shocks are quickly passed through to interest expenses.