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Stock prices and the risk-free rate: An internal rationality approach

Tongbin Zhang

Journal of Economic Dynamics and Control, 2021, vol. 127, issue C

Abstract: The co-movement of stock prices and the risk-free rate in the United States is weak in terms of the correlation and variance decomposition. It is essential for investors and policymakers to understand such co-movement, especially when several well-known asset pricing models imply a much stronger relationship than the one empirically observed. To explain this inconsistency, this paper presents a model with “internally rational” agents who optimally update their subjective beliefs about stock prices. Compared with the risk-free rate, agents’ subjective beliefs are essential for generating stock market volatility. Quantitatively, our model can jointly produce basic asset market facts and the weak co-movement.

Keywords: Stock prices; Risk-free rate; Internal rationality learning; Correlation; Variance decomposition (search for similar items in EconPapers)
JEL-codes: D84 E44 G12 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jedc.2021.104103

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Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

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