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What Ties Return Volatilities to Price Valuations and Fundamentals?

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  • Alexander David
  • Pietro Veronesi

Abstract

Stock and Treasury bond comovement, volatilities, and their relations to their price valuations and fundamentals change stochastically over time, in both magnitude and direction. These stochastic changes are explained by a general equilibrium model in which agents learn about composite economic and inflation regimes. We estimate our model using both fundamentals and asset prices and find that inflation news signal either positive or negative future real economic growth depending on the times, thereby affecting the direction of stock-bond comovement. The learning dynamics generate strong nonlinearities between volatilities and price valuations. We find empirical support for numerous predictions of the model.

Suggested Citation

  • Alexander David & Pietro Veronesi, 2013. "What Ties Return Volatilities to Price Valuations and Fundamentals?," Journal of Political Economy, University of Chicago Press, vol. 121(4), pages 682-746.
  • Handle: RePEc:ucp:jpolec:doi:10.1086/671799
    DOI: 10.1086/671799
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    References listed on IDEAS

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    1. Brandt, Michael W. & Santa-Clara, Pedro, 2002. "Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets," Journal of Financial Economics, Elsevier, vol. 63(2), pages 161-210, February.
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    3. Beeler, Jason & Campbell, John Y., 2012. "The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment," Critical Finance Review, now publishers, vol. 1(1), pages 141-182, January.
    4. Alexi Savov, 2011. "Asset Pricing with Garbage," Journal of Finance, American Finance Association, vol. 66(1), pages 177-201, February.
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