Group 11

Homework Week 10

Q1. What is cointegration? Why should consumption and income be cointegrated? Why should stock prices and dividends be cointegrated?

According to Sørensen (2005), cointegration is defined as a simple case of 2 time series xt and yt, that are both integrated of order one, is the following:

xt and yt are said to be cointegrated if there exists a parameter α such that ut = yt – αxt is a stationary process. Consumption and income should be cointegrated due to permanent income hypothesis implies that consumption is proportional to the total value of current assets. When the value of consumer’s assets increases, consumption should rise in proportion (Slacalek 2004). Referring back to the original definition, if both time series correlate together, it should be integrated into the order one. Brealey and Myers (1996) noted that Financial theory points out that in a well functioning capital market, the prices and dividends should be related by which the present value of the share should be equal to the dividend stream discounted by the return earned on securities of comparable risk. In pursuit of determining if stock prices and dividends are cointegrated, empirical studies have employed cointegration technique.

Q2. What is the point of the paper?

There are two basic points to the paper. The first being, shocks to the Gross National Produce (GNP) are virtually completely transitory when consumption is left constant. And also, shocks to the prices on the stock market are also virtually completely transitory if the value of dividend payouts is left as constant.

Q3. What do you make of an increase in stock prices without a corresponding increase in dividends? Is it likely to be permanent or transitory? Why?

A shock to stock market prices with no corresponding increase in dividends would mean it would have a an transitory effect on the prices trading in the market and no effect on the value of the dividends paid. Longer the swings in the dividend - price ratio the transitory movements in price happen over a lengthier horizon, with an approximate half-life of around five years.

Q4. What do you make of a drop in GDP that is accompanied by a fall in consumption? Is it likely to be a permanent or transitory shock?

Based on the graph, we can conclude that a fall in the consumption shock will influence the GNP movement trend. GNP has a hump-shaped response to the consumption shock. Despite so, this shock has a small impact on consumption at any horizon level and the response of GNP to this shock is almost transitory .

Q5. What does Cochrane mean by saying that consumption defines the trend in GDP?

It is suggested by Cochrane that there is a problem in forecasting the GNP due to it follow a random walk. This problem could be overcome with the use of the consumption/GNP ratio provide a promising forecasting for the long –horizon GNP growth assisted by it being stable over time when consumption and GNP are cointegrated. This suggests that consumption define the movement of GNP. To see the relation in between the 2 variables, it interprets the data using the permanent income model. The model suggests that consumption is a random walk and consumption and total income are cointegrated. I am taking the extract from the paper here, if consumption does not change, consumers must think any fluctuation in GNP is transitory. However, permanent income model should be rejected due to the fact that consumption is not a random but nevertheless it help to describe and interpret the VAR result

Reference.

Brealey, R. A. and Myers, S. C. 1986, Principle of Corporate Finance, McGraw Hill, London.

Slacalek J. 2004, International Evidence on Cointegration between Consumption , Income and Wealth, Department of Economics, John Hopkins University , viewed 18 October 2015, http://www.slacalek.com/research/sla04cointCAY/sla04cointCAY.pdf

Sørensen , B. E. 2005, Cointegration, viewed 18 October 2015, http://www.uh.edu/~bsorense/coint.pdf