Chilean Stock Market Expected Return Analysis: A Variance Decomposition

The main objective of this paper is to quantify the effect of expectation changes about discount rate and dividend growth rate over the Chilean market portfolio returns. The model applied was taken from the works of Campbell and Shiller (1988, 1988a), Campbell (1991) and Campbell and Vuolteenaho (2005). The model expresses the unexpected returns as a function of two components related with: (i). news about future dividends growth and (ii). news about future returns of the market portfolio. The results obtained for the period of 1995-2005 show that the component of news about future dividends explains most of the unexpected portfolio returns variance, contrary to Campbell and Vuolteenaho (2005) find in the US data. Indeed, the differences are explained by the lower persistence observed in the variables utilized in estimates; thus, the long term return forecasting is less acute, which augments the estimation errors and finally, the news about dividends growth importance. Considering some feature of the Chilean stock market such as legal, tax, ownership concentration and information quality, news about future returns should not be as important as in the US stock market. The model also allows to divide, the traditional beta of the Capital Asset Pricing Model (CAPM) in two components, i.e.: (i). a component related with the future cash flows and (ii). a component which reflect the relationship between the stock returns with the discount rates of the market portfolio. The results show that the high return observed in the small-value stocks, it due to their beta is predominated for the cash flow risk component. Thus, the adjustment obtained when beta is separating in these components improves relatively with those resulted from the traditional method. Unlike US, in Chile have not been developed a formal methodology that quantifies the incidence of changes in expectations of discount rates and dividends over stock prices. Additionally, this work is the first in applying an approach of decomposition of the systematic risk in Chilean data.