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The term structure of equity premia in an affine arbitrage-free model of bond and stock market dynamics

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  • Werner, Thomas
  • Lemke, Wolfgang

Abstract

We estimate time-varying expected excess returns on the US stock market from 1983 to 2008 using a model that jointly captures the arbitrage-free dynamics of stock returns and nominal bond yields. The model nests the class of affine term structure (of interest rates) models. Stock returns and bond yields as well as risk premia are affine functions of the state variables: the dividend yield, two factors driving the one-period real interest rate and the rate of inflation. The model provides for each month the `term structure of equity premia', i.e. expected excess stock returns over various investment horizons. Model-implied equity premia decrease during the `dot-com' boom period, show an upward correction thereafter, and reach highest levels during the financial turmoil that started with the 2007 subprime crisis. Equity premia for longer-term investment horizons are less volatile than their short-term counterparts. JEL Classification: E43, G12

Suggested Citation

  • Werner, Thomas & Lemke, Wolfgang, 2009. "The term structure of equity premia in an affine arbitrage-free model of bond and stock market dynamics," Working Paper Series 1045, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20091045
    Note: 336092
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp1045.pdf
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    References listed on IDEAS

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    Cited by:

    1. van Ewijk, Casper & de Groot, Henri L.F. & Santing, A.J. (Coos), 2012. "A meta-analysis of the equity premium," Journal of Empirical Finance, Elsevier, vol. 19(5), pages 819-830.
    2. Fernando M. Duarte & Carlo Rosa, 2015. "The equity risk premium: a review of models," Economic Policy Review, Federal Reserve Bank of New York, issue 2, pages 39-57.
    3. Damir Filipovi'c & Sander Willems, 2018. "A Term Structure Model for Dividends and Interest Rates," Papers 1803.02249, arXiv.org, revised May 2020.
    4. Stanislav Khrapov, 2012. "Risk Premia: Short and Long-term," Working Papers w0169, New Economic School (NES).
    5. J. Benson Durham, 2013. "Arbitrage-free models of stocks and bonds," Staff Reports 656, Federal Reserve Bank of New York.
    6. Damir Filipović & Sander Willems, 2020. "A term structure model for dividends and interest rates," Mathematical Finance, Wiley Blackwell, vol. 30(4), pages 1461-1496, October.
    7. J. Benson Durham, 2013. "More on U.S. Treasury term premiums: spot and expected measures," Staff Reports 658, Federal Reserve Bank of New York.

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    More about this item

    Keywords

    Affine term structure models; asset pricing; Equity premium;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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