Dynamics of Bond and Stock Returns
62 Pages Posted: 18 Apr 2015 Last revised: 31 Jan 2019
Date Written: January 30, 2019
I present a production-based general equilibrium model that jointly prices bond and stock returns. The model produces time-varying correlation between stock and long-term default-free real bond returns that changes in both magnitude and sign. The real term premium is also time-varying and changes sign. To generate these results, the model incorporates time-varying risk aversion within Epstein-Zin preferences and two physical technologies with different exposure to cash-flow risk. Bonds hedge risk-aversion (discount-rate) shocks and command negative term premium through this channel. Capital (cash-flow) shocks produce comovement of bond and stock returns and positive term premium. The relative strength of these two mechanisms varies over time.
Keywords: bonds, stocks, risk premium, general equilibrium
JEL Classification: E44
Suggested Citation: Suggested Citation