Stock Prices and the Risk-free Rate: An Internal Rationality Approach
55 Pages Posted: 28 May 2020 Last revised: 6 Apr 2021
Date Written: March 12, 2021
The co-movement of stock prices and the risk-free rate in the United States is weak in terms of the correlation and variance decomposition. It is essential for investors and policymakers to understand such co-movement, especially when several well-known asset pricing models imply a much stronger relationship than the one empirically observed. To explain this inconsistency, this paper presents a model with "internally rational" agents who optimally update their subjective beliefs about stock prices. Compared with the risk-free rate, agents' subjective beliefs are essential for generating stock market volatility. Quantitatively, our model can jointly produce basic asset market facts and the weak co-movement.
Keywords: stock prices, risk-free rate, internal rationality learning, correlation, variance decomposition
JEL Classification: G12, E44, D84
Suggested Citation: Suggested Citation