The Cross-Section and Time-Series of Stock and Bond Returns
Ralph S. J. Koijen
University of Chicago - Booth School of Business
Hanno N. Lustig
UCLA - Anderson School of Management; National Bureau of Economic Research (NBER)
Stijn Van Nieuwerburgh
New York University Stern School of Business, Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
NBER Working Paper No. w15688
We propose an arbitrage-free stochastic discount factor (SDF) 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, the dynamics of bond yields, and time series variation in expected stock and bond returns. Its pricing factors are motivated by a decomposition of the pricing kernel into a permanent and a transitory component. Shocks to the transitory component govern the level of the term structure of interest rates and price the cross-section of bond returns. Shocks to the permanent component govern the dividend yield and price the average equity returns. Third, shocks to the relative contribution of the transitory component to the conditional variance of the SDF govern the Cochrane-Piazzesi (2005, CP) factor, a strong predictor of future bond returns. These shocks price the cross-section of book-to-market sorted stock portfolios. Because the CP factor is a strong predictor of economic activity one- to two-years ahead, positive shocks to CP signal improving economic conditions, leading to a positive price of risk. Value stocks are riskier and carry a return premium because they are more exposed to such shocks.
Number of Pages in PDF File: 57working papers series
Date posted: February 1, 2010
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