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Stock prices and the risk-free rate: An internal rationality approach

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  • Zhang, Tongbin

Abstract

The co-movement of stock prices and the risk-free rate in the United States is weak in terms of the correlation and variance decomposition. It is essential for investors and policymakers to understand such co-movement, especially when several well-known asset pricing models imply a much stronger relationship than the one empirically observed. To explain this inconsistency, this paper presents a model with “internally rational” agents who optimally update their subjective beliefs about stock prices. Compared with the risk-free rate, agents’ subjective beliefs are essential for generating stock market volatility. Quantitatively, our model can jointly produce basic asset market facts and the weak co-movement.

Suggested Citation

  • Zhang, Tongbin, 2021. "Stock prices and the risk-free rate: An internal rationality approach," Journal of Economic Dynamics and Control, Elsevier, vol. 127(C).
    • Handle: RePEc:eee:dyncon:v:127:y:2021:i:c:s0165188921000385
    DOI: 10.1016/j.jedc.2021.104103
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    1. Magomet Yandiev, 2021. "Risk-Free Rate in the Covid-19 Pandemic: Application Mistakes and Conclusions for Traders," Papers 2111.07075, arXiv.org.

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    More about this item

    Keywords

    Stock prices; Risk-free rate; Internal rationality learning; Correlation; Variance decomposition;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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