Stock Prices and Risk-free Rate: An 'Internal Rationality' Approach
50 Pages Posted: 28 May 2020
Date Written: April 2020
The co-movement between stock and short-term bond markets in US is weak in terms of the correlation between asset prices, variance decomposition and impulse response. It is essential to investors and policy makers to understand it, especially when several well-known asset pricing models imply a much stronger relationship than empirically observed. To explain this inconsistency, this paper presents a model with "Internally Rational" agents, who optimally update their subjective beliefs on stock prices. Compared with risk-free rate, agents' subjective beliefs are essential in generating stock market volatility. Quantitatively our model can jointly match the asset markets moments and the weak co-movement.
Keywords: Stock Prices, Risk-Free Rate, Internal Rationality Learning, Correlation, Variance Decomposition
JEL Classification: G12, E44, D84
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