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The term structure of equity premia in an affine arbitrage-free model of bond and stock market dynamics

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  • Lemke, Wolfgang
  • Werner, Thomas

Abstract

We estimate time-varying expected excess returns on the US stock market from 1983 to 2008 using a model that jointly captures the arbitrage-free dynamics of stock returns and nominal bond yields. The model nests the class of affine term structure (of interest rates) models. Stock returns and bond yields as well as risk premia are affine functions of the state variables: the dividend yield, two factors driving the one-period real interest rate and the rate of inflation. The model provides for each month the `term structure of equity premia', i.e. expected excess stock returns over various investment horizons. Model-implied equity premia decrease during the `dot-com' boom period, show an upward correction thereafter, and reach highest levels during the financial turmoil that started with the 2007 subprime crisis. Equity premia for longer-term investment horizons are less volatile than their short-term counterparts. JEL Classification: E43, G12

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 1045.

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Date of creation: Apr 2009
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Handle: RePEc:ecb:ecbwps:20091045

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Keywords: Affine term structure models; asset pricing; Equity premium;

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  1. GlennD. Rudebusch & Tao Wu, 2008. "A Macro-Finance Model of the Term Structure, Monetary Policy and the Economy," Economic Journal, Royal Economic Society, vol. 118(530), pages 906-926, 07.
  2. Martin Lettau & Jessica A. Wachter, 2009. "The Term Structures of Equity and Interest Rates," NBER Working Papers 14698, National Bureau of Economic Research, Inc.
  3. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
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  9. d'Addona, Stefano & Kind, Axel H., 2006. "International stock-bond correlations in a simple affine asset pricing model," Journal of Banking & Finance, Elsevier, vol. 30(10), pages 2747-2765, October.
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Cited by:
  1. Stanislav Khrapov, 2012. "Risk Premia: Short and Long-term," Working Papers w0169, Center for Economic and Financial Research (CEFIR).
  2. van Ewijk, Casper & de Groot, Henri L.F. & Santing, A.J. (Coos), 2012. "A meta-analysis of the equity premium," Journal of Empirical Finance, Elsevier, vol. 19(5), pages 819-830.
  3. Durham, J. Benson, 2013. "Arbitrage-free models of stocks and bonds," Staff Reports 656, Federal Reserve Bank of New York.
  4. Durham, J. Benson, 2013. "Another view on U.S. Treasury term premiums," Staff Reports 658, Federal Reserve Bank of New York.

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