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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. Castro, Vítor, 2010. "The duration of economic expansions and recessions: More than duration dependence," Journal of Macroeconomics, Elsevier, vol. 32(1), pages 347-365, March.
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  15. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  16. Sousa, Ricardo M., 2010. "Housing wealth, financial wealth, money demand and policy rule: Evidence from the euro area," The North American Journal of Economics and Finance, Elsevier, vol. 21(1), pages 88-105, March.
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  19. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
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