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Nonlinearities in the Relation Between the Equity Risk Premium and the Term Structure

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Listed author(s):
  • Jacob Boudoukh

    (Stern School of Business, New York University, 44 W. 4th Street, New York, New York 10012)

  • Matthew Richardson

    (Stern School of Business, New York University, 44 W. 4th Street, New York, New York 10012)

  • Robert F. Whitelaw

    (Stern School of Business, New York University, 44 W. 4th Street, New York, New York 10012)

Registered author(s):

    Abstract

    This paper investigates the relation between the conditional expected equity risk premium and the slope of the term structure of interest rates. Theoretically, these variables are linked, the relation may be nonlinear, and negative risk premiums are consistent with equilibrium. Given these implications, we employ a nonparametric estimation technique to document the empirical relation between the risk premium and the slope of the term structure using almost two hundred years of data. Of particular interest, the risk premium is increasing in the term structure slope; however, for either small or negative slopes, the risk premium is much more sensitive to changes in interest rates. In addition, the empirical results imply negative expected equity risk premiums for some inverted term structures. Finally, variations in the risk premium do not appear to be related to variations in the variance of equity returns. We illustrate these features in a stylized consumption-based model, and provide the economic intuition behind the results.

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    File URL: http://dx.doi.org/10.1287/mnsc.43.3.371
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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 43 (1997)
    Issue (Month): 3 (March)
    Pages: 371-385

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    Handle: RePEc:inm:ormnsc:v:43:y:1997:i:3:p:371-385
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    Keywords: equity risk premium; predictability; nonlinearity; nonparametric;

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    Cited by:

    1. Doron Avramov, "undated". "Stock-Return Predictability and Model Uncertainty," Rodney L. White Center for Financial Research Working Papers 12-00, Wharton School Rodney L. White Center for Financial Research.
    2. Leonid Kogan & Raman Uppal, "undated". "Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies," Rodney L. White Center for Financial Research Working Papers 13-00, Wharton School Rodney L. White Center for Financial Research.
    3. Kothari, S. P. & Shanken, Jay, 1997. "Book-to-market, dividend yield, and expected market returns: A time-series analysis," Journal of Financial Economics, Elsevier, vol. 44(2), pages 169-203, May.
    4. Ross McCown, James, 2001. "Yield curves and international equity returns," Journal of Banking & Finance, Elsevier, vol. 25(4), pages 767-788, April.
    5. Yacine Aït-Sahalia, 2001. "Variable Selection for Portfolio Choice," Journal of Finance, American Finance Association, vol. 56(4), pages 1297-1351, 08.
    6. Jose Soares da Fonseca, 2010. "The performance of the European stock markets: a time-varying Sharpe ratio approach," The European Journal of Finance, Taylor & Francis Journals, vol. 16(7), pages 727-741.
    7. Ludvigson, Sydney C. & Ng, Serena, 2007. "The empirical risk-return relation: A factor analysis approach," Journal of Financial Economics, Elsevier, vol. 83(1), pages 171-222, January.
    8. Angelos Kanas, 2010. "A note on the relation between the equity risk premium and the term structure," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 34(1), pages 89-95, January.
    9. Robert F. Whitelaw, 1997. "Time-Varying Sharpe Ratios and Market Timing," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-074, New York University, Leonard N. Stern School of Business-.
    10. Ostdiek, Barbara, 1998. "The world ex ante risk premium: an empirical investigation," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 967-999, December.
    11. Robert J Bianchi & Adam E Clements & Michael E Drew, 2009. "HACking at Non-linearity: Evidence from Stocks and Bonds," School of Economics and Finance Discussion Papers and Working Papers Series 244, School of Economics and Finance, Queensland University of Technology.
    12. Angelos Kanas, 2009. "The relation between the equity risk premium and the bond maturity premium in the UK: 1900–2006," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 33(2), pages 111-127, April.
    13. Deng, Yongheng & Gabriel, Stuart A. & Sanders, Anthony B., 2011. "CDO market implosion and the pricing of subprime mortgage-backed securities," Journal of Housing Economics, Elsevier, vol. 20(2), pages 68-80, June.
    14. Eleswarapu, Venkat R. & Thompson, Rex, 2007. "Testing for negative expected market return premia," Journal of Banking & Finance, Elsevier, vol. 31(6), pages 1755-1770, June.

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