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Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities

Renatas Kizys () and Peter Spencer ()

No 140, Money Macro and Finance (MMF) Research Group Conference 2006 from Money Macro and Finance Research Group

Abstract: In this paper, we used modified multivariate EGARCH-M models to assess the relation between the equity risk premium, macroeconomic risk, and inflationary expectations. To rationalise this link between equity risk premia and macroeconomic volatilities, we built our empirical study on the stochastic discount factor (SDF) model. As an innovative feature of our empirical model, we used long-term government bond yields in order to explain this risk-return relation. Our research suggests that stock market investors should use long-term government bond yield for the UK and term spread for the US in order to instrument their assessment of stock market investment opportunities and riskiness. We also document that the relevance of the short-term interest rates has decreased over the last decade, whereas the relevance of the long-term government bond yields, by contrast, has increased. With regard to the risk-return relation, we found the UK investors tend to significantly price in inflation risk premia. Estimation results strongly suggest that the decline in macroeconomic volatilities might have played an increasingly important role in reducing risk premia in the US and, to some extent, in the UK

Keywords: Asset pricing; Risk premium; Macroeconomic volatility; Stochastic discount factor model; Multivariate EGARCH-M model (search for similar items in EconPapers)
JEL-codes: E32 E44 G12 (search for similar items in EconPapers)
Date: 2007-02-02
New Economics Papers: this item is included in nep-mac, nep-rmg and nep-upt
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