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Arbitrage-free models of stocks and bonds

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Abstract

A small but ambitious literature uses affine arbitrage-free models to estimate jointly U.S. Treasury term premiums and the term structure of equity risk premiums. Within this approach, this paper identifies the parameter restrictions that are consistent with a simple dividend discount model, extends the cross-section to Germany and France, averages across multiple observable-factor and market prices of risk specifications, and considers alternative samples for parameter estimation. The results produce intuitive trajectories for both sets of premiums given standard samples starting from July 1993. However, the decomposition of nominal U.S. Treasury yields, but not long-run equity risk premiums, is sensitive to data beyond 2008, which raises some questions about the net effects of unconventional monetary policy measures. Nonetheless, the rotation from sharp inversion during the financial crisis to an upward-sloping term structure of equity risk premiums more recently, with modest readings at the front end, is not inconsistent with some net moderation in required compensation for equity risk in the United States.

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  • Durham, J. Benson, 2013. "Arbitrage-free models of stocks and bonds," Staff Reports 656, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:656
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    References listed on IDEAS

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    1. Koijen, Ralph S.J. & Lustig, Hanno & Van Nieuwerburgh, Stijn, 2017. "The cross-section and time series of stock and bond returns," Journal of Monetary Economics, Elsevier, vol. 88(C), pages 50-69.
    2. Granger, Clive W. J. & Uhlig, Harald F., 1990. "Reasonable extreme-bounds analysis," Journal of Econometrics, Elsevier, vol. 44(1-2), pages 159-170.
    3. Kim, Don H. & Orphanides, Athanasios, 2012. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(01), pages 241-272, April.
    4. d'Addona, Stefano & Kind, Axel H., 2006. "International stock-bond correlations in a simple affine asset pricing model," Journal of Banking & Finance, Elsevier, vol. 30(10), pages 2747-2765, October.
    5. 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.
    6. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
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    Cited by:

    1. Duarte, Fernando M. & Rosa, Carlo, 2015. "The equity risk premium: a review of models," Economic Policy Review, Federal Reserve Bank of New York, issue 2, pages 39-57.

    More about this item

    Keywords

    equity risk premium; Treasury term premium; affine arbitrage-free models;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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