Stock Return and Cash Flow Predictability : The Role of Volatility Risk

We examine the joint predictability of return and cash flow within a present value framework, by imposing the implications from a long-run risk model incorporating both time varying volatility and volatility uncertainty. We provide new evidence that the expected return variation and the variance risk premium positively forecast both short-horizon returns and dividend growth rates. Our equilibrium-based “structural” factor GARCH model permits much more accurate inference than the reduced form VAR and univariate regression procedures traditionally employed in the literature. The model also allows for the direct estimation of the underlying “structural” shocks and economic transmission mechanisms, including a new volatility leverage effect