Working Paper: NBER ID: w14698
Authors: Martin Lettau; Jessica A. Wachter
Abstract: This paper proposes a dynamic risk-based model capable of jointly explaining the term structure of interest rates, returns on the aggregate market and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upward-sloping yield curve, the failure of the expectations hypothesis and the poor performance of the capital asset pricing model.
Keywords: term structure; equity; interest rates; risk-based model; stochastic discount factor
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shocks to dividend growth (G35) | pricing of risk (G19) |
| real interest rate (E43) | pricing of risk (G19) |
| expected inflation (E31) | pricing of risk (G19) |
| price of risk (G19) | upward slope of the yield curve (E43) |
| real risk-free rate (E43) | risk premium for long-term bonds (G12) |
| shocks to underlying economic fundamentals (E32) | time-varying price of risk (G19) |
| time-varying price of risk (G19) | predictability in excess returns on the aggregate market (G17) |