On the Fundamental Relation between Equity Returns and Interest Rates

51 Pages Posted: 11 Jun 2014

See all articles by Jaewon Choi

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance

Matthew P. Richardson

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); AQR Capital Management, LLC

Robert Whitelaw

New York University; National Bureau of Economic Research (NBER)

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Date Written: June 2014

Abstract

This paper uses contingent claim asset pricing and exploits capital structure priority to better understand the relation between corporate security returns and interest rate changes (i.e., duration). We show theoretically and, using a novel dataset, confirm empirically that lower priority securities in the capital structure, such as subordinated or distressed debt and equity, have low or even negative durations because these securities are effectively short higher priority, high duration fixed rate debt. This finding has important implications for interpreting existing results on (i) the time-varying correlation between the aggregate stock market and government bonds, (ii) the use of bond factors for multifactor asset pricing models and forecasting bond and stock returns, (iii) the Fisher effect and inflation, and (iv) the betas of corporate bonds.

Suggested Citation

Choi, Jaewon and Richardson, Matthew P. and Whitelaw, Robert F., On the Fundamental Relation between Equity Returns and Interest Rates (June 2014). NBER Working Paper No. w20187. Available at SSRN: https://ssrn.com/abstract=2448873

Jaewon Choi (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

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Matthew P. Richardson

New York University (NYU) - Department of Finance ( email )

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National Bureau of Economic Research (NBER)

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AQR Capital Management, LLC ( email )

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Robert F. Whitelaw

New York University ( email )

Stern School of Business
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New York, NY 10012-1126
United States
212-998-0338 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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