Equity Valuation Under Stochastic Interest Rates
This paper presents an equity valuation model that employs risk-neutral valuation under stochastic interest rates along the lines of Ohlson and Feltham (1999). Closed form valuation formulae for equities are presented in a discrete time setting whereby the short term interest rate is modelled by a quadratic term structure model. Earnings are driven by mean reverting return on equity (ROE). The term strcture of interest rates, and in particular the variance of the future short rates, is found to be a primary dterminant of equity value tat has been largely overlooked by the previous equity valuation literature. Equity value decreases in the correlation between the short interest rate and ROE and can be very sensitive to such correlation when the ROE process is very persistent. This suggests that equity value dreceases in the degree of pro-cyclicality of the firm's profitability.
|Date of creation:||Jun 2006|
|Contact details of provider:|| Postal: Department of Economics and Related Studies, University of York, York, YO10 5DD, United Kingdom|
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- Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
- Markus Leippold & Liuren Wu, 2002. "Design and Estimation of Quadratic Term Structure Models," Finance 0207014, EconWPA.
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- Dong-Hyun Ahn & Robert F. Dittmar, 2002. "Quadratic Term Structure Models: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 243-288, March.
- Realdon, Marco, 2006. "Quadratic term structure models in discrete time," Finance Research Letters, Elsevier, vol. 3(4), pages 277-289, December.
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