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Wealth, Labour Income, Stock Returns and Government Bond Yields, and Financial Stress in the Euro Area

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I show that when the ratio of asset wealth to human wealth falls, investors become more exposed to idiosyncratic shocks and demand higher stock and government bond risk premia. I find that the residuals from the cointegrating vector among asset wealth and labour income, wy, predict both future stock and bond returns in the Euro Area. Consequently, it can be used to track time-variation in risk premium. The results are robust to the inclusion of control variables and vis-a-vis other benchmark models. Finally, I show that, conditioning the predictive ability of wy on the financial stress conditions allows one to track better future time-variation in risk premium. Moreover, when financial stress increases, investors perceive a larger risk for both stocks and government bonds.

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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 22/2011.

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Date of creation: 2011
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Handle: RePEc:nip:nipewp:22/2011

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Keywords: wealth; income; stock returns; government bond yields;

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  1. Peter C.B. Phillips & Sam Ouliaris, 1987. "Asymptotic Properties of Residual Based Tests for Cointegration," Cowles Foundation Discussion Papers 847R, Cowles Foundation for Research in Economics, Yale University, revised Jul 1988.
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  15. Castro, Vítor, 2008. "The duration of economic expansions and recessions : More than duration dependence," The Warwick Economics Research Paper Series (TWERPS) 860, University of Warwick, Department of Economics.
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  19. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 457-510.
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