Stock Prices and the Risk-free Rate: An Internal Rationality Approach

55 Pages Posted: 28 May 2020 Last revised: 6 Apr 2021

See all articles by Tongbin Zhang

Tongbin Zhang

Shanghai University of Finance and Economics

Date Written: March 12, 2021

Abstract

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

Zhang, Tongbin, Stock Prices and the Risk-free Rate: An Internal Rationality Approach (March 12, 2021). Journal of Economic Dynamics and Control, 2021, Available at SSRN: https://ssrn.com/abstract=3589925 or http://dx.doi.org/10.2139/ssrn.3589925

Tongbin Zhang (Contact Author)

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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