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

50 Pages Posted: 28 May 2020

See all articles by Tongbin Zhang

Tongbin Zhang

Shanghai University of Finance and Economics

Date Written: April 2020

Abstract

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

Suggested Citation

Zhang, Tongbin, Stock Prices and Risk-free Rate: An 'Internal Rationality' Approach (April 2020). 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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