Equity Valuation Under Stochastic Interest Rates
AbstractThis paper presents an equity valuation model that employs risk-neutral valuation under stochastic interest rates along the lines of Ohlson and Feltham (1999). Closed form valuation formulae for equities are presented in a discrete time setting whereby the short term interest rate is modelled by a quadratic term structure model. Earnings are driven by mean reverting return on equity (ROE). The term strcture of interest rates, and in particular the variance of the future short rates, is found to be a primary dterminant of equity value tat has been largely overlooked by the previous equity valuation literature. Equity value decreases in the correlation between the short interest rate and ROE and can be very sensitive to such correlation when the ROE process is very persistent. This suggests that equity value dreceases in the degree of pro-cyclicality of the firm's profitability.
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Bibliographic InfoPaper provided by Department of Economics, University of York in its series Discussion Papers with number 06/12.
Date of creation: Jun 2006
Date of revision:
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Postal: Department of Economics and Related Studies, University of York, York, YO10 5DD, United Kingdom
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More information through EDIRC
Equity valuation; residual income valuation; stochastic interest rates; quadratic term structure model in discrete time; mean reverting return on equity;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
This paper has been announced in the following NEP Reports:
- NEP-ACC-2006-06-24 (Accounting & Auditing)
- NEP-ALL-2006-06-24 (All new papers)
- NEP-CFN-2006-06-24 (Corporate Finance)
- NEP-FIN-2006-06-24 (Finance)
- NEP-FMK-2006-06-24 (Financial Markets)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Markus Leippold & Liuren Wu, 2002. "Design and Estimation of Quadratic Term Structure Models," Finance 0207014, EconWPA.
- Marco Realdon, 2006.
"Quadratic Term Structure Models in Discrete Time,"
06/01, Department of Economics, University of York.
- Dong-Hyun Ahn & Robert F. Dittmar, 2002. "Quadratic Term Structure Models: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 243-288, March.
- Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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