The Term Structures of Equity and Interest Rates / Martin Lettau, Jessica A. Wachter.

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Lettau, Martin

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w14698.Publication details: Cambridge, Mass. National Bureau of Economic Research 2009.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: This paper proposes a dynamic risk-based model capable of jointly explaining the term structure of interest rates, returns on the aggregate market and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upward-sloping yield curve, the failure of the expectations hypothesis and the poor performance of the capital asset pricing model.

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Working Paper	Biblioteca Digital	Colección NBER	nber w14698 (Browse shelf(Opens below))	Not For Loan

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Previous	nber w14695 The Economics and Psychology of Inequality and Human Development /	nber w14696 Reflections on Americans' Views of the Euro Ex Ante /	nber w14697 The Demand for Youth: Implications for the Hours Volatility Puzzle /	nber w14698 The Term Structures of Equity and Interest Rates /	nber w14699 Measuring the Financial Sophistication of Households /	nber w1470 Developing Country Debt and the Market Value of Large Commercial Banks /	nber w14700 New Estimation of China's Exchange Rate Regime /	Next

January 2009.

This paper proposes a dynamic risk-based model capable of jointly explaining the term structure of interest rates, returns on the aggregate market and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upward-sloping yield curve, the failure of the expectations hypothesis and the poor performance of the capital asset pricing model.