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Options Implied Dividend Yield and Market Returns

Version: September 2008


This paper proposes a new variable for the analysis of the stock market return predictability.
Recognizing that expected dividends are time-varying, I show that the variation in the expected
return can be captured by the expected dividend yield. Using options implied dividend yield
(IDY ) to proxy for the expected dividend yield, I nd that the IDY serves as a strong predictor
for monthly and quarterly market excess returns. Indeed, the IDY predicts returns better than
the traditionally used realized dividend-price ratio, the earnings-price ratio, the consumption-to-
wealth ratio, the average implied correlation and the variance risk premium. To underpin the
results, I further show that the implied dividend growth (inferred from the IDY ) predicts the
future dividend growth.
Key Words: options implied dividend yield, dividend-price ratio, predictability
1. INTRODUCTION
Can the stock market return be predicted? This question has deep economic implica-
tions and has been the subject of much empirical and theoretical research. However, there
is still no consensus on whether market returns are predictable. While many studies claim
that returns can be predicted by variables such as the dividend-price ratio (11) or the
earnings-price ratio (11),
1
a large body of the literature casts doubt on the documented
predictability.
2
Generally, the evidence seems to suggest that the return predictability
is rather weak for short horizons and is the strongest for multi-year.
3
In this study, I
re-examine the role of dividend ratios for predicting returns. Instead of relying on the
traditionally used realized 11, I employ an expected dividend yield extracted from index
options (implied dividend yield - 111 ). I show that 111 serves as a strong predictor
for Dow Jones Industrial Average returns in the post 1997 period.
4
Indeed, 111 predicts
monthly and quarterly returns better than a series of alternative predictor variables, such
as 11, 11, consumption-to-wealth ratio (C1 ), variance risk premia and options implied
average correlation.
5
1
See Keim and Stambaugh (1986), Fama and French (1988), Campbell and Shiller (1989), Lewellen
(2004) and Cochrane (2006) among others.
2
See Goetzmann and Jorion (1995), Lanne (2002), Valkanov (2003), Boudoukh et al. (2007) among
others.
3
One exception to this rule is variance risk premia recently analyzed by Bollerslev et al. (2008). The
variance risk premia, dened as the dierence between the implied and the realized variance, is found to
have the strongest ability to predict returns at the intermediate (quarterly) horizon.
4
The period under analysis is limited by data availability.
5
Predictability of market returns with the realized average correlation was rst considered by Pollet and
Wilson (2007). This study is the rst to show that options implied correlation predicts returns.
1
Predictability of market returns with the dividend-price ratio has been extensively stud-
ied.
6
According to the standard view, if dividend growth is unpredictable, all the uctua-
tions in the 11 come from the variations in the expected returns.
7
However, recent evi-
dence suggests that the dividend growth is predictable and the expected dividend growth
is time-varying.
8
As a result, the 11 uctuates not only because of the variations in the
expected returns, but also because of the changes in the expected dividend growth.
9
This
makes the 11 a noisy proxy for the expected returns and diminishes its ability to predict
returns.
10
To account for the variation in the expected dividend growth, van Binsbergen
and Koijen (2008) propose a linear regression of returns on the price-dividend ratio and
an estimate for the expected dividend growth. I demonstrate that the expected return is
a function of the product between the 11 and the expected dividend growth. Therefore,
instead of relying on the predictive regression with the 11 and the expected dividend
growth as two separate variables, we should consider predicting returns with the product
of both variables, an expected dividend yield. This approach alleviates the multicollinearity
problems and allows for the non-linear relation between the expected returns, the 11 and
the expected dividend growth. Accordingly, it makes the prediction more precise.
Following this intuition, the main innovation of this paper lies in the estimation of the
expected dividend yield. Unlike the previous studies that estimate the expected dividends
from the past data,
11
or they obtain them from the analyst forecasts,
12
I use options
implied dividend yield (111 ) as a proxy for the expected dividend yield. The 111 is
extracted from the European index options by applying the put-call parity.
13
Thus, it
relies exclusively on the observed market prices and should therefore reveal the "true"
markets expected dividend yield.
For a comparison with the 111 , I employ a series of alternative predictor variables. In
addition to the more traditional predictor variables (11, 11 and C1 ), I also estimate
two options implied predictors, average implied correlation and variance risk premia. A
combination of the 111 and the alternative predictors provides a rich framework for the
empirical analysis, but poses certain data limitations. Construction of the average implied
correlation is rather cumbersome and possible only for indices with a small number of
stocks. Estimation of the 111 is limited to the indices with European options. As a
result, the analysis is restricted to Dow Jones Industrial Average (DJIA) between October
1997 and December 2006.
The main empirical results are the following. In line with the previous studies, the 11
serves as a rather poor predictor for short-run returns. It explains 3 5% of the variation
6
First study dates back to 1920 (Dow) and the most inuential paper on dividend ratios by Fama and
French (1988) has 325 ocial citations.
7
See Cochrane (2006) among others.
8
See Lettau and Ludvingson (2005), Ribeiro (2004) and Van Binsbergen and Koijen (2008).
9
See Campbell and Shiller (1988) and Van Binsbergen and Koijen (2008) among others.
10
See Fama and French, 1988; Kothari and Sanken, 1992; Goetzmann and Jorion, 1995; Menzly et al.,
2004; Lettau and Ludvingson, 2005 and Rytchkov, 2006 among others.
11
See van Binsbergen and Koijen (2008) and Rytchkov (2006) among others.
12
See Chen and Zhao (2008) among others.
13
This is a frequently used approach for estimating expected dividend yield in the options literature. See
Ait-Sahalia and Lo (1998) and Buraschi and Jiltsov (2006) among others.
2
in the future quarterly excess returns. In comparison, 111 exhibits a 1
2
of 19%. This is
signicantly more than the 1
2
for the 11 (1
2
= 4%) and the C1 (1
2
= 3%). Further,
111 also outperforms the average implied correlation (1
2
= 14%) and the variance risk
premia (1
2
= 14%).
Results are robust to a battery of robustness checks and they are not driven by the
specic features of the 1J1. On the contrary, the S&P 500 implied dividend yield explains
22% of the variation in the quarterly S&P 500 returns. To underpin the return regression
results and to validate the initial motivation, I further show that the implied dividend
growth (inferred from the 111 ) predicts DJIA quarterly dividend growth with a 1
2
of
31%.
The rest of the paper is organized as follows. Section 2 motivates the use of the expected
dividend yield for predicting market returns. Section 3 presents the data. Summary statis-
tics and predictive regressions with the dividend ratios are reported in Section 4. Section
5 compares predictive ability of the dividend ratios to the alternative predictor variables.
Section 6 concludes the paper.
2. PAST VS. EXPECTED DIVIDENDS
Motivating predictive regressions
The dividend-price ratio is one of the most frequently employed variables in the return
predictability literature. It is dened as the ratio between the dividends accumulated over
the past period and the current price, 1
t
,1
t
. Assuming prices are determined by the dis-
counted value of future dividends, 1
t
,1
t
combines forward-looking prices and dividends
that are old relative to prices (Fama and French, 1988). As a result, uctuations in the
1
t
,1
t
can be interpreted in two ways. Firstly, 1
t
,1
t
reects the rate at which future divi-
dends are discounted to the current price. When discount rates are high, prices are low and
the 1
t
,1
t
is high. Therefore, the dividend-price ratio co-varies with the expected returns.
Secondly, a high ratio could be a signal of low future dividends. When investors expect
lower dividends in the future, the current price decreases and boosts the 1
t
,1
t
. Taken
together, a high 1
t
,1
t
is associated with either high expected returns, or low expected
dividends, or both.
This relationship was rst formalized by Campbell and Schiller (1989). Log-linearizing
the denition for the raw return, they show that the log dividend-price ratio can be ex-
pressed in terms of all the future one period expected returns adjusted for the expected
dividend growth rate. Just recently, van Binsbergen and Koijen (2008) develop a closed-
form present-value model in which they demonstrate that the price-dividend ratio is an
exact linear function of the expected return and the expected dividend growth.
I concentrate on the dividend-price ratio and present its relation to the expected return
and the expected dividend growth in a simplied setting. Consider the denition for the
3
expected return, j
r;t
j
r;t
= 1
t

1
t+1
+ 1
t+1
1
t

(1)
where 1
t
denotes the price at time t and 1
t+1
stands for the dividends accumulated
between t and t + 1. As in Ang and Liu (2007), rewrite (1)
j
r;t
=
1
t
1
t
1
t

1
t+1
1
t

1
t
"
1
D
t+1
P
t+1
+ 1
#!
(2)
where 1
t
,1
t
is the dividend-price ratio, 1
t
[1
t+1
,1
t
] is the expected dividend growth
and 1
t
[1
t+1
,1
t+1
] is the expected value of the next periods dividend-price ratio. To
simplify, assume that the next periods dividend-price ratio is equal to the long-term average
of the dividend-price ratio, 1
t
h
D
t+1
P
t+1
i
= 11.
14
Hence, the third term in the equation (2)
becomes a constant and expected return can be expressed as
j
r;t
=
1
t
1
t
1
t

1
t+1
1
t

/ (3)
where / = 1,11 + 1. Rewriting (3), we obtain an expression for the 1
t
,1
t
.
1
t
1
t
=
j
r;t
1
t
[1
t+1
,1
t
] /
(4)
Equation (4) says that 1
t
,1
t
is positively related to the expected return and inversely
related to the expected dividend growth rate and /. Accordingly, high 1
t
,1
t
should predict
either (i) high future return, or (ii) low future dividend growth rate, or (iii) both.
In line with this intuition, the standard approach in the empirical literature is to regress
returns, r
t+1
, and dividend growth rates, 1
t+1
, on the lagged 1
t
,1
t
1
t+1
= a
0
+ a
1
(1
t
,1
t
) + -
d;t+1
(5)
r
t+1
= /
0
+ /
1
(1
t
,1
t
) + -
r;t+1
(6)
The typical nding from regression (5) is that 1
t
,1
t
does not predict dividend growth
(Cochrane, 1992, 2001, 2006). This is usually interpreted as the lack of time-variability in
the expected dividend growth and this suggests that most of the variaton in the 1
t
,1
t
is
due to uctuations in the expected returns. As stated by Cochrane (2006), if 1
t
,1
t
does
not predict dividend growth, it should predict returns. However, ndings from the return
predictive regression (6) are rather mixed. On the one side, many studies nd that the
1
t
,1
t
predicts returns, especially over the long-run (Fama and French, 1988; Campbell and
Shiller, 1988; Lewellen, 2004; Cochrane, 2006). On the other side, several academics argue
14
This assumption is used to avoid iterating forward the dividend-price ratio and to provide a simple
intuition for the predictive regressions. Even though the assumption is rather strict, it is not unrealistic.
Investros have a better idea of the next periods expected returns and the next periods expected dividend
growth rate than the next periods dividend-price ratio, which in turn depends on the expected returns and
the expected dividend growth rates of the even more distant future. Also, most studies in the predictability
literature assume some form of the mean-reversion for the dividend-price ratio.
4
that the statistical evidence for the documented predictability is not reliable (Goetzman
and Jorion, 1995; Lanne, 2002; Valkanov, 2003; Boudoukh et al., 2007). Also, Goyal and
Welch (2005) show that the 1
t
,1
t
does not predict returns out-of-sample.
One of the reasons for the low ability of the 1
t
,1
t
for predicting returns is related to the
time-variability of the expected dividend growth. Namely, recent literature shows that the
lack of dividend growth predictability by the 1
t
,1
t
does not imply that expected dividends
are constant. Lettau and Ludvingson (2005) nd that the dividend growth is predictable
by variables other than the 1
t
,1
t
. Van Binsbergen and Koijen (2008) demonstrate that
regression (5) suers from the errors-in-variables problem that occurs when one does not
control for the expected returns. They nd that the adjusted 1
2
for the annual post-war
dividend growth rises from 2% to 15% once controlled for the expected returns ltered
from the past data
15
. Thus, on the contrary to the standard belief, this evidence suggests
that the expected dividend growth varies over time. This makes the 1
t
,1
t
a noisy proxy
for the expected return and diminishes its ability to predict returns (Fama and French,
1988; Lettau and Ludvingson, 2005). Specically, when expected dividend growth is time
varying, equation (4) shows that the 1
t
,1
t
uctuates not only because of the variation
in the expected return, but also because of the changes in the expected dividend growth
(see also Campbell and Shiller, 1989 and van Binsbergen and Koijen, 2008). Hence, to
capture variation in the expected returns, we should take into account uctuations in both
the 1
t
,1
t
and the expected dividend growth.
Motivated by the closed-form present value model, van Binsbergen and Koijen (2008)
account for the variation in the expected dividends by including an estimate for the expected
dividend growth as an additional regressor in the price-dividend return regression. Using
total payout ratio, they report that 1
2
for annual post-war returns increases from 15% to
17% once controlled for the expected dividend growth ltered from the past price-dividend
ratios and the past dividend growth rates.
Along similar lines of reasoning, we could augment predictive regression (6) by the
expected dividend growth:
r
t+1
= c
0
+ c
1
(1
t
,1
t
) + c
2
1
t
[1
t+1
] + -
t+1
(7)
Nevertheless, equation (3) shows that the expected return is a non-liner function of
the 11 and the expected dividend growth. This suggests that the linear regression (7)
is misspecied and therefore, does not incorporate the full information contained in the
1
t
,1
t
and the 1
t
[1
t+1
] . To account for the non-linearity, equation (3) implies that we
should replace the 1
t
,1
t
and the expected dividend growth by its product, an expected
dividend yield, 1
t
[1
t+1
,1
t
] .
j
r;t
=
1
t
1
t
1
t

1
t+1
1
t

/ = 1
t

1
t+1
1
t

/ (8)
Hence, instead of relying on the predictive regression (7), we should consider predicting
15
Note: Van Binsbergen and Koijen (2008) concenrate on the price-dividend ratio instead of the dividend-
price ratio.
5
returns with the expected dividend yield:
r
t+1
= d
0
+ d
1
1
t
[1
t+1
,1
t
] + -
t+1
(9)
The appealing feature of the predictive regression (9) is that it relies on a single predictor
variable and therefore alleviates the multicollinearity problems. Also, it takes into account
the non-linear relationship between the expected returns, the 11 and the expected dividend
growth. Consequently, it makes the prediction more precise.
Estimation of expected dividend yield
The remaining challenge is the estimation of the expected dividends (expected dividend
yield).
16
Recent literature considers two ways for extracting expected dividends. Expected
dividends are estimated either from the observed history of past data (Rytchkov, 2006;
van Binsbergen and Koijen, 2008) or they are obtained directly from the analyst forecasts
(Chen and Zhou, 2008).
In this paper, I employ options implied dividend yield (111 ) as a proxy for the expected
dividend yield. The 111 is extracted from the index options by applying the put-call parity.
The put-call parity relates the price of a European call option (C) and a European put
option (1) to the current price of the underlying (o), the present value of the strike price
(1\ (1)) and the present value of the future dividends 1\ (1i):
1 + o = C + 1\ (1) + 1\ (1i) (10)
Accordingly, we can infer implied dividends or the 111 from the observed market prices
(Ait-Sahalia and Lo, 1998; Buraschi and Jiltsov, 2006).
This approach has several advantages over alternative methods for estimating expected
dividends. Unlike extracting expected dividends from the observed history of past divi-
dends, the 111 is obtained without any assumptions about the dynamics of the dividends.
Specically, the put-call parity is independent of options pricing models and hence the
111 is obtained in a model-free way. Further, because any violation of the put-call par-
ity gives rise to the arbitrage prots, the 111 is not likely to be subject to behavioral
biases that were found to inuence the analyst forecasts.
17
Lastly, the 111 is based exclu-
sively on the observed stock and option prices. Since options have long been recognized as
forward-looking, the 111 should serve as a good proxy for the markets expected dividend
yield.
18
16
Expected dividend growth is obtained from the dividend-price ratio and the expected dividend yield.
17
Doukas et al. (2006), for example, nd that stock returns are positively related to the analysts
divergence of opinion.
18
The forward-looking nature of options is also frequently exploited for predicting market volatility Poon
and Granger (2005) makes a survey of this literature and concludes that options implied volatility generally
predicts future volatility better than the volatility models based on the past data.
6
3. DATA
The empirical analysis is based on Dow Jones Industrial Average (DJIA). This choice of
data is motivated by two considerations. Firstly, options on DJIA are European and hence
the put-call parity can be applied directly. Secondly, DJIA includes only 30 stocks and is
rarely subject to composition changes, so that the alternative predictor variables (average
implied correlation) can be constructed easily. Despite the small number of constituents, it
is by no means a negligible index. DJIA is the most widely cited index among practitioners
and accounts for about a fth of the whole market capitalization of all the U.S. stocks.
19
The data comes from several sources. DJIA prices (with and without reinvested div-
idends) are obtained directly from the Dow Jones. Daily T-bill rates are extracted from
CRSP. All the information on options comes from OptionMetrics Ivy DB. Unfortunately,
the data on the DJIA options is not available before autumn 1997. This restricts the period
under analysis to the time between October 1997 and December 2006.
The implied dividend yield, 111 , is downloaded directly from the Ivy DB Index Div-
idend Yields le.
20
Under the put-call parity relationship and the assumption of a con-
tinuously compounded dividend yield, Ivy DB estimates the implied dividend yield from a
linear regression model:
C 1 = c
0
+ c
1
o + c
2
oT + c
3
1 + c
4
1T + c
5
1
BA
(11)
where C 1 is the dierence between the price of a call and a put option with the
same strike price (1) and expiration (T) for a given underlying (o). To accommodate
for the bid ask spread, the bid price of a call is used with the ask price of the put, and
vice versa. 1
BA
is a binary variable that equals 1 when the bid price for the call is used
and 0 otherwise. To estimate the model, Ivy DB uses 10 days of backward-looking data
for all strikes and expirations. The 111 is approximately equal to the negative value of
the estimated parameter b c
2
.
21
To guarantee comparability with other dividend ratios, I
transform continuously compounded dividend yield into a raw dividend yield.
The dividend-price ratio, 11, is estimated according to the standard procedure (Cochrane,
2006):
11
t
=
1
t
1
t
=
1
t
+ 1
t
1
t1
1
t1
1
t
1 =
1
D
t
1
ND
t
1 (12)
where 1
D
t
is the total return and the 1
ND
t
is the return without the reinvested divi-
dends.
22
Since the focus of the study is on the predictability of the short run returns, I
primarily rely on the dividend-price ratio calculated on 91 days (o:c nartcr) of backward-
looking data.
23
19
Under robustness checks, I also consider predicting S&P 500 returns.
20
I purposely rely on this data source to remedy data mining concerns and to enable easy replicability
of the presented results.
21
Further details are provided in the Ivy DB Reference Manual.
22
I calculate R
D
t
and R
ND
t
from the DJIA total prices and the DJIA prices without the reinvested
dividends, respectively.
23
Under robustness checks, I also employ an annual DP ratio calculated on 365 days of backward-looking
data.
7
The implied dividend growth, 11G, is calculated from the 111 and the 11:
11G
t
= 111
t
(1
t
,1
t
) = 111
t
,11
t
(13)
To test whether the implied dividend growth (implied dividend yield) predicts the future
realized dividend growth (future realized dividend yield), I also estimate the future realized
dividend yield, 111, and the future realized dividend growth, 11G, on 91-days of forward-
looking data:
111
t+1
=
1
t+1
1
t
=
1
t+1
1
t+1
1
t+1
1
t
=
1
t+1
1
t+1
1
ND
t
(14)
11G
t+1
= 111
t+1
(1
t
,1
t
) (15)
In addition to the dividend ratios, I consider a set of alternative predictor variables,
such as the earnings-price ratio (Shiller, 1984), the consumption-to-wealth ratio (Lettau
and Ludvingson, 2001), the variance risk premia (Bollerslev et al., 2008)
24
and the average
correlation (Pollet and Wilson, 2007).
25
The earnings-price ratio, 11, is obtained from Datastream and the consumption-to-
wealth ratio, C1 , is downloaded directly from the Lettau and Ludvingsons website.
The average implied correlation, j
IM
, is calculated as in Skintzi and Refenes (2003):
j
IM
t
=
o
2
P;t

P
N
i=1
n
2
i;t
o
2
i;t
2
P
N1
i=1
n
i;t
n
j;t
o
i;t
o
j;t
(16)
where o
2
P;t
is the DJIA implied variance, o
2
i;t
is the implied variance of the DJIA compo-
nents ( = 30) and n
i;t
is the price-weight of each DJIA constituent.
26;27
Implied variance
for the DJIA and all its components is estimated on xed 30 days maturity options following
the estimation technique of Bakshi et al. (2003)
28
.
The variance risk premia, \ 11, is dened as the dierence between the DJIA annual-
ized 30 days implied variance and the DJIA annualized lagged realized variance estimated
over 91 days of backward-looking data.
29
Realized DJIA variance is estimated as a sum-
mation of squared 30 minutes returns.
24
Bollerslev et al. (2008) show that the variance risk premia, dened as the dierence between the options
implied variance and the lagged realized variance, forecasts returns because it captures uctuations in the
economic uncertainty and the aggregate risk aversion.
25
Pollet and Wilson (2007) nd that average pair-wise correlations among stocks predict returns because
they serve as a good proxy for the aggregate risk.
26
Unlike the majority of the U.S. indices, DJIA is a price-weighted index.
27
In the period between October 1997 and December 2006, there was alltogether 7 DJIA index compo-
sition changes. In addition, 8 companies had their names changed.
28
I extract the required data from the OptionMetics Ivy DB Volatility Surface le (for a similar approach
see Driessen et al., 2006).
29
Bollerslev et al. (2008) dene VRP as the dierence between the xed 30-days options implied variance
and the 30 days lagged realized variance. I use the 91-days lagged realized variance (instead of the 30-days
lagged realized variance) because I nd that the VRP constructed in this way possesses superior forecasting
power.
8
4. PRELIMINARY RESULTS
The empirical analysis is divided in two sections. This section (Preliminary Results)
analyses predictability of market returns using the dividend ratios. The next section (Main
Results) compares the return-predictive ability of the dividend ratios with the alternative
predictor variables.
4.1. Summary statistics
Table 1 reports basic summary statistics for the employed variables. The annualized
mean DJIA log excess return is 1.86%.
30
This low excess return is driven by a relatively
high risk-free rate and a big downward stock market correction at the beginning of the new
millennium.
The dividend-price ratio (11) is historically relatively low and amounts to 1.95. Since
the dividends exhibit positive growth (11G = 1.03), the mean realized dividend yield
(111 ) is slightly higher than the 11 and amounts to 2.00. The proxy for the expected
dividend growth (11G) and the proxy for the expected dividend yield (111 ) are both
slightly higher than the 11G and the 111 . Nevertheless, the dierences are small (11G
amounts to 1.06 and 111 is 2.07). The 11G and the 111 are also more volatile than
their realized counterparts. With respect to the higher moments, the employed variables
appear to be normally distributed. The only exception is the 11G, which is extremely
positively skewed and exhibits a high excess kurtosis.
Table 1 also reports rst-order autocorrelation coecients for the employed variables.
Consistent with the previous studies, the 11 is very persistent and exhibits an autocor-
relation coecient of 0.92. In comparison, the rst order autcorrelation coecient for the
111 is slightly lower and amounts to 0.88.
4.2. Predicting dividend growth and dividend yield
Section II shows that the 11 is a function of the expected returns and the expected
dividend growth rate. This implies that the return predictability depends not only on the
observable 11, but also on a proxy for the expected dividend growth. The better the
proxy for the expected dividend growth, the better we can predict returns. Therefore, I
rst test how well the proposed proxy for the expected dividend growth (implied dividend
growth) predicts the future realized dividend growth.
Figure 1.a plots the realized dividend growth together with the implied dividend growth.
11G uctuates between 0.8 and 1.3 throughout the analyzed period. 11G is more volatile
than the 11G and exhibits several spikes and troughs. Nevertheless, the 11G seems to
30
Even though Section II motivates predictive regressions for raw returns, I instead base the empirical
part on the log excess returns. This is done merely because most of the studies in the predictablity literature
analyse forecastability of the log excess returns.
9
capture variations in the 11G reasonably well. This is also conrmed by the regression in
which the realized dividend growth is regressed on the lagged implied dividend growth:
11G
t+1
= )
0
+ )
1
(11G
t
) + -
t+1
(17)
Table 2 (Panel A) reports results for quarterly non-overlapping observations. The esti-
mated parameter is 0.41 and the 1
2
amounts to 31%.
31
Thus, the implied dividend growth
indeed predicts the future dividend growth. This result is in stark contrast to the conven-
tional wisdom - that the dividend growth is unpredictable - and clearly indicates that the
expected dividend growth is time-varying. Therefore, adding the 11G as an additional
regressor in the standard 11 predictive regression should signicantly improve the return
predictability.
Section II further implies that the 11 and the proxy for the expected dividend growth
(implied dividend growth) can be replaced by a proxy for the expected dividend yield
(implied dividend yield). Therefore, I additionally consider how well the 111 predicts the
future realized dividend yield. Since 11G predicts the future dividend growth and the 111
is a simple product of the 11G and the 11, the 111 should serve as a strong predictor
for the future dividend yield.
Figure 1.b plots the time series of the future realized dividend yield (111 ) together
with the implied dividend yield (111 ). 111 uctuates between 1% and 3% throughout
the analyzed period. It exhibits the lowest values at the time of the market boom at the
turn of the millennium and a signicant rise in the subsequent years of a downward market
correction. As expected, the 111 exhibits several spikes and troughs, but seems to track
uctuations in the 1G1 well. To underpin the visual interpretation, I regress the realized
dividend yield on the lagged implied dividend yield:
111
t+1
= q
0
+ q
1
(111
t
) + -
t+1
(18)
Table 2 (Panel B) presents results for quarterly non-overlapping observations. The
estimated parameter is 0.64 and the 1
2
amounts to 65%.
32
Hence, the 111 indeed strongly
predicts the future realized dividend yield and should therefore also serve as a good predictor
for the future returns.
4.3. Predicting DJIA returns
To test for the predictability of market returns, I consider three specications for the
return predictive regressions. The rst is the standard 11 predictive regression:
r
t+1
= /
0
+ /
1
(11
t
) + -
t+1
(19)
31
In comparison, the lagged dividend growth rate is negatively related to the future dividend growth
rate.
32
In comparison, the lagged dividend yield predicts only 28% of the variation in the future dividend yield.
10
This return regression does not take into account that the 11 is a function of both
the expected returns and the expected dividend growth. Therefore, the second regression
augments the rst by the proxy for the expected dividend growth (implied dividend growth):
r
t+1
= c
0
+ c
1
(11
t
) + c
2
(11G
t
) + -
t+1
(20)
To account for the nonlinear relationship between the 11
t
and the 11G
t
and to remedy
the multicollinearity problems, the third return regression replaces the dividend-price ratio
and the proxy for the expected dividend growth with the proxy for the expected dividend
yield (implied dividend yield):
r
t+1
= d
0
+ d
1
(111
t
) + -
t+1
(21)
Table 3 reports regression results for quarterly (91 days) non-overlapping excess returns.
All the predictors have positive signs. The 11 explains 5% of the variation in the quarterly
returns. By including the 11G in the 11 regression, 1
2
triples and jumps to 14%. This
conrms that the expected return depends not only on the 11, but also on the expected
dividend growth. Moreover, the expected dividend growth seems to be at least as important
predictor as the 11
33
. Results from the third regression further revel that the 111 predicts
returns even better than the 11 and 11G separately. Specically, 111 explains as much
as 19% of the variation in the quarterly excess returns. This result is in line with the the
initial conjecture and conrms that the non-linear structure among the return, the expected
dividend growth and the 11 indeed plays an important role for predicting returns
34
.
Additionally, I evaluate the results from predicting monthly (30 days) excess returns.
Table 4 details results. As expected, the degree of predictability is signicantly lower.
Nevertheless, the main conclusions remain the same and the 111 stands out again. It
explains around 5% of the variation in the monthly returns. In comparison, the joint
regression of the 11 and the 11G exhibits a 1
2
of 3%. The 11 explains only 1% of the
variation in the monthly returns.
5. MAIN RESULTS
In order to assess the predictive power of the implied dividend yield, we have to compare
it with the alternative predictor variables. The recent literature has proposed several
variables that predict returns. In addition to the dividend-price ratio, the most frequently
33
In comparison, van Binsbergen and Koijen (2008) report that the expected dividend growth only has
a moderate inuence on the predictability of the future returns. The dierence between their results and
my results is most probably driven by the dierent methods for estimating expected dividend growth.
34
For a comparison, I estimate the return regression with the DP, IDG and their product (IDY ):
r
t+1
= g
0
+g
1
(DP
t
) +g
2
(IDG
t
) +g
3
(IDY
t
)"
t+1
(22)
Results are outlined in Table 3 (Panel D). The R
2
jumps to 26%, therby conming that the expected
return is indeed a non-linear function of the DP and the expected dividend growth. Nevetheless, this
regression may be subject to the multicolinearity problems (e.g. g
1
and g
2
are negative). Therefore, R
2
may also be exaggerated.
11
employed predictors are the earnings-price ratio, 11, (Shiller, 1984) and the consumption-
to-wealth ratio, C1 , (Lettau and Ludvingson, 2001). Just recently, the menu of predictors
has been extended by the variance risk premia (Bollerslev et al., 2008) and the average
correlation (Pollet and Wilson, 2007). The average pair-wise correlation among stocks, j,
is found to predict returns because it is a good proxy for the aggregate risk. The variance
risk premia, \ 11, dened as the dierence between the options implied variance and
the lagged realized variance, serves as a good predictor for returns because it captures
uctuations in the economic uncertainty and the aggregate risk aversion.
The j and the \ 11 are of special interest for this study. They are both extracted from
the options data and therefore present the most relevant comparison for the 111 .
Summary statistics
Table 5 reports the basic summary statistics and the unconditional correlation structure
for all the predictors (since the C1 is available only on the quarterly frequency, summary
statistics are based on the end-of-quarter observations). The numbers are all in line with
the previous studies. Except for the variance risk premia, all the predictors are relatively
highly persistent.
Predictive Regressions
I begin by reporting in Table 6 the results for quarterly return regressions. Not sur-
prisingly and in line with the previous research, the traditional predictor variables serve
as rather poor predictors for future returns. C1 and 11 explain approximately 3% and
4% of the variation in the quarterly excess returns, respectively. Unlike the traditional pre-
dictor variables, the implied correlation and the variance risk premia are both statistically
signicant predictors and exhibit 1
20
: of approximately 14%.
35
Despite this seemingly high
predictive ability, neither of them outperforms the adjusted 1
2
of 19% for the 111 .
Similar results are obtained for monthly return regressions. As outlined in Table 7, only
the options-related predictors surpass the usual test of statistical signicance. Nonetheless,
their predictive power is well below the one of the 111 .
35
Results for the variance risk premia are directly in line with Bollerslev et al. (2008) who report that
the spread between the implied and the past variance explains 15% of the variation in quarterly S&P
500 returns in the time span between 1990 and 2005. The high predictive power of the average implied
correlation is new. Pollet and Wilson (2007) test predictive power of average correlations using past daily
data and report an R
2
of 5% for 30 years of quarterly observations. Driessen et al. (2006) calculate average
implied correlations for S&P 100 for 8 years of data, but report no predictive power for monthly returns.
However, they do not consider forecasting returns over longer horizons.
12
6. ROBUSTNESS CHECKS
In order to address concerns regarding the validity of the presented results, I consider
a battery of robustness checks.
Predicting excess returns (without the reinvested dividends)
Initially, I based predictive regressions on the total returns. Nevertheless, a similar
relation can be also derived for the returns without the reinvested dividends:
j
nd
r;t
= 1
t

1
t+1
1
t

=
1
t
1
t
1
t

1
t+1
1
t

= 1
t

1
t+1
1
t

(23)
where /

= 1
t
h
1,
P
t+1
D
t+1
i
= 1,11. Therefore, for the rst robustness check, I re-run
the predictive regressions for the excess returns without the reinvested dividends. Table
8 reports results for quarterly non-overlapping observations. The predictive ability of the
dividend ratios remains largely unaected when the total excess returns are replaced by
the excess returns without the reinvested dividends. The predictive power decreases only
marginally and the 111 still explains 18% of the variation in the quarterly excess returns.
Annualized dividend-price ratio
The main empirical analysis is based on the 11 calculated over 91 days of data (one
quarter). However, the dividend payments exhibit within-year variations and hence the
11 may be aected by the seasonal uctuations. Therefore, for the second robustness
check, I re-run the predictive regressions with the dividend-price ratio calculated over one
year (365 days) of backward-looking data (11
Ann:
). Table 9 outlines results for quarterly
non-overlapping observations. The 11
Ann:
exhibits 1
2
of approximately 3%. This is
around 2 percentage points less than the 1
2
for the 11. Thus, replacing the 11 with
the 11
Ann:
only widens the dierence in the return predictive ability between the realized
dividend-price ratio and the implied dividend yield.
Predicting S&P 500 returns
For the last robustness check, I address the concern that the results may be driven by
the unique features of the Dow Jones Index. DJIA is the only price-weighted U.S. market
index and includes only 30 most prominent stocks. Therefore, it is necessary to test whether
111 also predicts returns of a broader S&P 500 index.
36
Following the procedures of the
previous section, I extract the S&P 500 111 and total excess returns for the matching time
period between October 1997 and December 2006. Figure 2 plots the 111 for the S&P
500 along with the 111 for the DJIA. The S&P 500 implied dividend yield is somewhat
lower than the DJIA implied dividend yield. Also, it exhibits less pronounced spikes and
troughs. However, both 111 0: behave similarly and exhibit an unconditional pair-wise
correlation of 65%.
S&P 500 implied dividend yield also serves as a good predictor for the S&P 500 returns.
For the quarterly horizon, it explains as much as 22% of the variation in the future excess
returns. The 1
2
for the monthly returns amounts to 5%.
36
Options on S&P 500 are European.
13
7. CONCLUSION
I propose a new variable for the analysis of the stock market return predictability.
Recognizing that the expected dividends are time-varying, I show that the variation in
the expected return can be captured by the product of the dividend-price ratio and the
expected dividend growth, an expected dividend yield.
Following this motivation, I use the options implied dividend yield (111 ) as a proxy for
the expected dividend yield. I nd that the 111 serves as a strong predictor for monthly
and quarterly excess returns. Indeed, 111 predicts returns better than the traditionally
used realized dividend-price ratio. Moreover, 111 also outperforms earnings-price ratio,
consumption-to-wealth ratio, average implied correlation and variance risk premium. To
underpin the return regression results and to validate the initial motivation, I further show
that the implied dividend growth (inferred from the 111 ) predicts the future dividend
growth.
To my knowledge, this is the rst study to employ the options implied dividend yield
for predicting market returns. Results are promising, but a lot is left for my future work.
Do the same results hold for the implied dividend yield extracted from the index futures?
How does the 111 t in the traditional risk-return relation? Additionally, I also consider
extending the analysis to the cross-section of stock returns.
14
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16
Table 1: Summary Statistics
1
m;t+1
1
f;t+1
11
t
11G
t
111
t
11G
t
111
t
Mean 0.0186 1.9508 1.0301 2.0017 1.0619 2.0769
Std. Dev. 0.1586 0.3524 0.1331 0.4058 0.2369 0.5677
Skewness -0.4002 0.0074 0.4404 0.1211 1.0879 -0.1776
Kurtosis 3.4087 2.0524 3.4994 2.2025 7.0140 3.1602
Autocorrelation -0.0240 0.9265 0.4881 0.8839 0.7505 0.8803
Table presents summary statistics for 110 end-of-month observations between October 1997
and December 2006. 1
m;t+1
1
f;t+1
is the annualized 30 days log return in excess of the T-bill
rate. 11
t
is the dividend-price ratio calculated on 91 days of backward-looking data. 11G
t
and
111
t
are the future realized dividend growth and the future realized dividend yield, respectively.
They are both calculated on 91 days of forward-looking data. 11G
t
and 111
t
are the implied
dividend growth and the implied dividend yield, respectively. All the dividend ratios are multiplied
by 100.
17
Table 2: Predictive regressions for DJIA Realized Dividend Growth and
Realized Dividend Yield
Panel A: Predicting dividend growth
1:tcrccjt 11G
t
ad,.1
2
0.5972 0.4106 0.3106
(4.85) (3.52)
Panel B: Predicting dividend yield
1:tcrccjt 111
t
ad,.1
2
0.6576 0.6442 0.6507
(4.98) (7.71)
Table presents predictive regressions for the DJIA dividend growth and the dividend yield.
Panel A outlines results obtained by regressing 91 days future realized dividend growth (11G
t+1
)
on the lagged implied dividend growth (11G
t
). Panel B presents results obtained by regressing 91
days future realized dividend yield (111
t+1
) on the lagged implied dividend yield (111
t
). All
the results are based on OLS regressions with 36 end-of-quarter observations from December 1997
until October 2006. Statistical signicance of parameters is measured with Newey-West t-statistics
with 4 lags.
18
Table 3: Predictive Regressions for Quarterly DJIA Total Excess Returns
1:tcrccjt 11
t
11G
t
111
t
ad,.1
2
Panel A: Standard predictive regression
-0.1161 0.0624 0.0497
(-2.37) (2.63)
Panel B: Std. predictive regression + expected dividend growth
-0.2405 0.0578 0.1237 0.1363
(-2.51) (2.40) (2.04)
Panel C: Predictive regressions with the expected dividend yield
-0.1361 0.0673 0.1876
(-2.40) (2.96)
Panel D: Multivariate regression
0.9135 -0.5798 -1.0374 0.6366 0.2568
(3.46) (-3.78) (-3.83) (4.09)
Table presents results obtained by regressing quarterly DJIA total excess returns between
October 1997 and December 2006 on the lagged predictor variables. Risk-free rate is 90 days T-
bill rate. 11
t
is the dividend-price ratio calculated on 91 days of backward-looking data, 11G
t
is the implied dividend growth and 111
t
is the implied dividend yield. All the results are based
on OLS regression with 36 non-overlapping observations extracted on the last day of each quarter.
Statistical signicance of the parameters is measured with Newey-West t-statistics with 4 lags.
19
Table 4: Predictive Regressions for Monthly DJIA Total Excess Returns
1:tcrccjt 11
t
11G
t
111
t
ad,.1
2
Panel A: Standard predictive regression
-0.0334 0.0179 0.0102
(-2.47) (2.67)
Panel B: Std. predictive regression + expected dividend growth
-0.0631 0.0165 0.0304 0.0265
(-2.52) (2.15) (1.70)
Panel C: Predictive regressions with the expected dividend yield
-0.0376 0.0188 0.0469
(-2.46) (2.94)
Panel D: Multivariate regression
0.3080 -0.1972 -0.3391 0.2111 0.0887
(4.88) (-5.31) (-5.69) (6.05)
Table presents results obtained by regressing monthly DJIA total excess returns between Oc-
tober 1997 and December 2006 on the lagged predictor variables. Risk-free rate is 90 days T-bill
rate. 11
t
is the dividend-price ratio calculated on 91 days of backward-looking data, 11G
t
is
the implied dividend growth and 111
t
is the implied dividend yield. All the results are based on
OLS regression with 110 non-overlapping observations extracted on the last day of each month.
Statistical signicance of the parameters is measured with Newey-West t-statistics with 12 lags.
20
Table 5: Summary Statistics and Unconditional Correlation Structure
For Final Comparison
11
t
C1
t
j
IM
t
\ 11
t
111
t
Panel A: Summary statistics
Mean 0.0464 -0.0107 0.3120 0.0193 2.0971
Std. Dev. 0.0061 0.0106 0.1275 0.0190 0.5619
Skewness 0.0094 -0.1858 0.8440 1.3981 -0.3874
Kurtosis 2.2102 2.6175 3.2295 5.3122 2.2287
Autocorrelation 0.5765 0.6409 0.6061 0.1053 0.5964
Panel B: Unconditional correlation structure
11
t
1.0000 0.2154 -0.2503 -0.1411 0.2309
C1
t
. 1.0000 0.2886 0.1786 0.6966
j
IM
t
. . 1.0000 0.7764 0.3079
\ 11
t
. . . 1.0000 0.2440
111
t
. . . . 1.0000
Table presents summary statistics and unconditional correlation structure for end-of-quarter
observations between October 1997 and December 2006. 11
t
is the earnings-price ratios, C1
t
is the consumption-to-wealth ratio, j
IM
t
is the average implied correlation, \ 11
t
is the variance
risk premia and 111
t
is the implied dividend yield.
21
Table 6: Predictive Regressions for Quarterly DJIA Total Excess Returns
1:tcrccjt 11
t
C1
t
j
IM
t
\ 11
t
111
t
ad,.1
2
-0.1532 3.4115 0.0361
(-1.65) (1.75)
0.0242 1.7950 0.0265
(1.48) (2.84)
-0.0774 0.2641 0.1427
(-2.12) (2.82)
-0.0284 1.7324 0.1350
(-1.37) (2.88)
-0.1361 0.0673 0.1876
(-2.40) (2.96)
-0.1527 0.0897 0.8765 0.0538 0.2411
(-3.84) (0.67) (1.01) (2.55)
Table presents results obtained by regressing quarterly DJIA total excess returns between
October 1997 and December 2006 on the lagged predictor variables. Risk-free rate is 90 days
T-bill rate. 11
t
is the earnings-price ratios, C1
t
is the consumption-to-wealth ratio, j
IM
t
is the
average implied correlation, \ 11
t
is the variance risk premia and 111
t
is the implied dividend
yield. All the results are based on OLS regression with 36 non-overlapping observations extracted
on the last day of each quarter. Statistical signicance of the parameters is measured with Newey-
West t-statistics with 4 lags.
22
Table 7: Predictive Regressions for Monthly DJIA Total Excess Returns
1:tcrccjt 11
t
j
IM
t
\ 11
t
111
t
ad,.1
2
-0.0369 0.8305 0.0035
(-1.31) (1.48)
-0.0181 0.0613 0.0186
(-1.98) (2.24)
-0.0039 0.3144 0.0067
(-0.75) (2.02)
-0.0376 0.0188 0.0469
(-2.46) (2.94)
-0.0481 0.0170 0.2888 0.0188 0.0516
(-3.47) (0.33) (1.00) (2.82)
Table presents results obtained by regressing monthly DJIA total excess returns between Oc-
tober 1997 and December 2006 on the lagged predictor variables. Risk-free rate is 90 days T-bill
rate. 11
t
is the earnings-price ratios, C1
t
is the consumption-to-wealth ratio, j
IM
t
is the aver-
age implied correlation, \ 11
t
is the variance risk premia and 111
t
is the implied dividend yield.
All the results are based on OLS regression with 110 non-overlapping observations extracted on
the last day of each month. Statistical signicance of the parameters is measured with Newey-West
t-statistics with 12 lags.
23
Table 8: First Robustness Check:
Predictive Regressions for Quarterly DJIA Excess Returns
(w/o. Reinvested Dividends)
1:tcrccjt 11
t
11G
t
111
t
ad,.1
2
Panel A: Standard predictive regression
-0.1173 0.2428 0.0451
(-2.39) (2.54)
Panel B: Std. predictive regression + expected dividend growth
-0.2404 0.2243 0.1223 0.1296
(-2.50) (2.31) (2.01)
Panel C: Predictive regressions with the expected dividend yield
-0.1384 0.0660 0.1803
(-2.43) (2.89)
Table presents results obtained by regressing quarterly DJIA total excess returns between
October 1997 and December 2006 on the lagged predictor variables. Risk-free rate is 90 days T-
bill rate. 11
t
is the dividend-price ratio calculated on 91 days of backward-looking data, 11G
t
is the implied dividend growth and 111
t
is the implied dividend yield. All the results are based
on OLS regression with 36 non-overlapping observations extracted on the last day of each quarter.
Statistical signicance of the parameters is measured with Newey-West t-statistics with 4 lags.
24
Table 9: Second Robustness Check
Predictive Regressions for Quarterly DJIA Excess Returns
(Annual Dividend-Price Ratio)
1:tcrccjt 11
Ann::
t
11G
t
111
t
ad,.1
2
Panel A: Standard predictive regression
-0.1154 0.0622 0.0327
(-2.53) (2.88)
Panel B: Std. predictive regression + expected dividend growth
-0.2389 0.0568 0.1242 0.1198
(-2.29) (2.35) (2.01)
Panel C: Predictive regressions with the expected dividend yield
-0.1361 0.0673 0.1876
(-2.40) (2.96)
Table presents results obtained by regressing quarterly DJIA total excess returns between
October 1997 and December 2006 on the lagged predictor variables. Risk-free rate is 90 days
T-bill rate. 11
Ann:
t
is the dividend-price ratio calculated on 365 days of backward-looking data,
11G
t
is the implied dividend growth and 111
t
is the implied dividend yield. All the results are
based on OLS regression with 36 non-overlapping observations extracted on the last day of each
quarter. Statistical signicance of the parameters is measured with Newey-West t-statistics with
4 lags.
25
Figure 1: Dividend Yield and Dividend Growth
Figure 1.a: Realized and implied dividend growth
30.6.1998 29.12.2000 30.6.2003 30.12.2005
0.5
1
1.5
2
Realized dividend growth
Implied dividend growth
Figure 1.a: Realized and implied dividend yield
30.6.1998 29.12.2000 30.6.2003 30.12.2005
0.5
1
1.5
2
2.5
3
3.5
4
Realized dividend yield
Implied dividend yield
Figure A plots monthly observations of the 91 days realized dividend growth together with the
implied dividend growth. Figure B plots monthly observations of the 91 days realized dividend
yield together with the implied dividend yield. The data is based on the Dow Jones Industrial
Average in the period between October 1997 and December 2006.
26
Figure 2: S&P 500 and DJIA Implied Dividend Yield
30.6.1998 29.12.2000 30.6.2003 30.12.2005
0.5
1
1.5
2
2.5
3
3.5
4
4.5
Implied dividend yield
S&P 500
DJIA
The gure plots monthly observations of the implied dividend yield for the S&P 500 and the
DJIA between October 1997 and December 2006.
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