The Term Structures of Equity and Interest Rates

Martin Lettau () and Jessica A. Wachter ()

No 14698, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G12 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-fmk and nep-mon
Date: 2009-01
Note: AP
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