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Equity Valuation Under Stochastic Interest Rates

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Abstract

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.

Suggested Citation

  • Marco Realdon, 2006. "Equity Valuation Under Stochastic Interest Rates," Discussion Papers 06/12, Department of Economics, University of York.
  • Handle: RePEc:yor:yorken:06/12
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    References listed on IDEAS

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    1. 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.
    2. Realdon, Marco, 2006. "Quadratic term structure models in discrete time," Finance Research Letters, Elsevier, vol. 3(4), pages 277-289, December.
    3. 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.
    4. Markus Leippold & Liuren Wu, 2002. "Design and Estimation of Quadratic Term Structure Models," Finance 0207014, University Library of Munich, Germany.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    More about this item

    Keywords

    Equity valuation; residual income valuation; stochastic interest rates; quadratic term structure model in discrete time; mean reverting return on equity;

    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
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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