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Stock market fluctuations and the term structure

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  • Chunsheng Zhou
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    Abstract

    This paper uses the term structure of interest rates to explain the variations of stock prices and stock returns. It shows that interest rates have an important impact on stock returns, especially at long horizons. The hypothesis that expected stock returns move one-for-one with ex ante interest rates, which has been rejected strongly in other studies using short horizon data, is supported by long horizon data. The paper proposes, for the first time, a single measure---the present value of forward interest rates---to summarize the information of the term structure that is useful in characterizing the comovements of the equity market and the bond market, and finds that such a single measure explains a significant part of variation in dividend-price ratios. The paper also suggests that the high volatility of the stock market is related to the high volatility of long-term bond yields and may be accounted for by changing forecasts of discount rates. The findings of this paper are quite different from the typical findings of the previous work and may provide a reasonable economic explanation for the predictability of long-horizon stock returns.

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    File URL: http://www.federalreserve.gov/pubs/feds/1996/199603/199603abs.html
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    File URL: http://www.federalreserve.gov/pubs/feds/1996/199603/199603pap.pdf
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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 96-3.

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    Date of creation: 1996
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    Handle: RePEc:fip:fedgfe:96-3

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    Keywords: Stock market;

    References

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    1. John Y. Campbell, 1995. "Some Lessons from the Yield Curve," Harvard Institute of Economic Research Working Papers 1713, Harvard - Institute of Economic Research.
    2. Ferson, Wayne E & Korajczyk, Robert A, 1995. "Do Arbitrage Pricing Models Explain the Predictability of Stock Returns?," The Journal of Business, University of Chicago Press, vol. 68(3), pages 309-49, July.
    3. N. Gregory Mankiw & David Romer & Matthew D. Shapiro, 1985. "An Unbiased Reexamination of Stock Market Volatility," Cowles Foundation Discussion Papers 758, Cowles Foundation for Research in Economics, Yale University.
    4. Shiller, Robert J. & Beltratti, Andrea E., 1992. "Stock prices and bond yields : Can their comovements be explained in terms of present value models?," Journal of Monetary Economics, Elsevier, vol. 30(1), pages 25-46, October.
    5. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
    6. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
    7. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
    8. Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
    9. Bekaert, Geert & Hodrick, Robert J, 1992. " Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets," Journal of Finance, American Finance Association, vol. 47(2), pages 467-509, June.
    10. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Wiley Blackwell, vol. 58(3), pages 495-514, May.
    11. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    12. John H. Cochrane, 1992. "Explaining the Variance of Price Dividend Ratios," NBER Working Papers 3157, National Bureau of Economic Research, Inc.
    13. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
    14. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
    15. Summers, Lawrence H, 1986. " Does the Stock Market Rationally Reflect Fundamental Values?," Journal of Finance, American Finance Association, vol. 41(3), pages 591-601, July.
    16. Stulz, Rene M, 1986. " Asset Pricing and Expected Inflation," Journal of Finance, American Finance Association, vol. 41(1), pages 209-23, March.
    17. Kenneth D. West, 1986. "Dividend Innovations and Stock Price Volatility," NBER Working Papers 1833, National Bureau of Economic Research, Inc.
    18. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
    19. James M. Poterba & Lawrence H. Summers, 1987. "Mean Reversion in Stock Prices: Evidence and Implications," NBER Working Papers 2343, National Bureau of Economic Research, Inc.
    20. Robert B. Barsky, 1986. "Why Don't the Prices of Stocks and Bonds Move Together?," NBER Working Papers 2047, National Bureau of Economic Research, Inc.
    21. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
    22. Schwert, G William, 1981. "The Adjustment of Stock Prices to Information about Inflation," Journal of Finance, American Finance Association, vol. 36(1), pages 15-29, March.
    23. Singleton, Kenneth J, 1980. "Expectations Models of the Term Structure and Implied Variance Bounds," Journal of Political Economy, University of Chicago Press, vol. 88(6), pages 1159-76, December.
    24. Shmuel Kandel & Robert F. Stambaugh, . "Modeling Expected Stock Returns for Long and Short Horizons," Rodney L. White Center for Financial Research Working Papers 42-88, Wharton School Rodney L. White Center for Financial Research.
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    Cited by:
    1. Aiolfi, Marco & Favero, Carlo A, 2003. "Model Uncertainty, Thick Modelling and the Predictability of Stock Returns," CEPR Discussion Papers 3997, C.E.P.R. Discussion Papers.
    2. Cowan, Adrian M. & Joutz, Frederick L., 2006. "An unobserved component model of asset pricing across financial markets," International Review of Financial Analysis, Elsevier, vol. 15(1), pages 86-107.
    3. Cifarelli, Giulio & Paladino, Giovanna, 2005. "Volatility linkages across three major equity markets: A financial arbitrage approach," Journal of International Money and Finance, Elsevier, vol. 24(3), pages 413-439, April.
    4. Laopodis, Nikiforos T., 2009. "Fiscal policy and stock market efficiency: Evidence for the United States," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 633-650, May.
    5. Kim, Sangbae & In, Francis, 2007. "On the relationship between changes in stock prices and bond yields in the G7 countries: Wavelet analysis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 17(2), pages 167-179, April.

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