The Term Structures of Equity and Interest Rates

67 Pages Posted: 31 Jan 2009 Last revised: 31 Aug 2010

See all articles by Martin Lettau

Martin Lettau

University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Date Written: January 2009

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.

Suggested Citation

Lettau, Martin and Wachter, Jessica A., The Term Structures of Equity and Interest Rates (January 2009). NBER Working Paper No. w14698, Available at SSRN: https://ssrn.com/abstract=1335723

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

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Centre for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

The Wharton School
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United States
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215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

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United States

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