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On the Fundamental Relation Between Equity Returns and Interest Rates

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  • Jaewon Choi
  • Matthew P. Richardson
  • Robert F. Whitelaw

Abstract

This paper uses contingent claim asset pricing and exploits capital structure priority to better understand the relation between corporate security returns and interest rate changes (i.e., duration). We show theoretically and, using a novel dataset, confirm empirically that lower priority securities in the capital structure, such as subordinated or distressed debt and equity, have low or even negative durations because these securities are effectively short higher priority, high duration fixed rate debt. This finding has important implications for interpreting existing results on (i) the time-varying correlation between the aggregate stock market and government bonds, (ii) the use of bond factors for multifactor asset pricing models and forecasting bond and stock returns, (iii) the Fisher effect and inflation, and (iv) the betas of corporate bonds.

Suggested Citation

  • Jaewon Choi & Matthew P. Richardson & Robert F. Whitelaw, 2014. "On the Fundamental Relation Between Equity Returns and Interest Rates," NBER Working Papers 20187, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20187
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    Cited by:

    1. Hossein Asgharian & Charlotte Christiansen & Ai Jun Hou, 2016. "Macro-Finance Determinants of the Long-Run Stock–Bond Correlation: The DCC-MIDAS Specification," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 14(3), pages 617-642.
    2. Aslanidis, Nektarios & Christiansen, Charlotte & Cipollini, Andrea, 2019. "Predicting bond betas using macro-finance variables," Finance Research Letters, Elsevier, vol. 29(C), pages 193-199.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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