Working Paper: CEPR ID: DP9024
Authors: Ralph Koijen; Hanno Lustig; Stijn Van Nieuwerburgh
Abstract: Value stocks have higher exposure to innovations in the nominal bond risk premium than growth stocks. Since the nominal bond risk premium measures cyclical variation in the market?s assessment of future output growth, this results in a value risk premium provided that good news about future output lowers the marginal utility of wealth today. In support of this mechanism, we provide new historical evidence that low return realizations on value minus growth, typically at the start of recessions when nominal bond risk premia are low and declining, are associated with lower future dividend growth rates on value minus growth and with lower future output growth. Motivated by this connection between the time series of nominal bond returns and the cross-section of equity returns, we propose a parsimonious three-factor model that jointly prices the cross-section of returns on portfolios of stocks sorted on book-to-market dimension, the cross-section of government bonds sorted by maturity, and time series variation in expected bond returns. Finally, a structural dynamic asset pricing model with the business cycle as a central state variable is quantitatively consistent with the observed value, equity, and nominal bond risk premia.
Keywords: bond risk premium; cross-section of stock returns
JEL Codes: E21; E43; G00; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| decrease in the bond risk premium (G12) | lower future dividend growth rates for value stocks (G35) |
| low realizations of the cp factor (E23) | lower future dividend growth rates on value minus growth stocks (G35) |
| periods of low cp realizations (E32) | significant declines in macroeconomic activity (E66) |
| three-factor model (C38) | explains observed value premium (G40) |
| value stocks (G12) | higher covariance with innovations in the nominal bond risk premium (E49) |
| recessions (E32) | significant cash flow shocks for value stocks (G32) |
| good news about future output growth (O49) | value risk premium (G17) |