Inflation as the Source of the Bond, Equity, and Value Premia
30 Pages Posted: 6 May 2022 Last revised: 23 May 2022
Date Written: May 18, 2022
A no-arbitrage pricing model with inflation as the only priced risk factor explains the bond, equity, and value premia observed in the United States over the past sixty years. Even though inflation is the only priced factor, in an economy with three state variables - inflation, the real rate, and corporate profitability - the real rate and profitability play a crucial role because of their sensitivity to inflation shocks. For bonds, the shape of excess returns with respect to maturity depends on the dynamic interactions between the three state variables. For stocks, the equity and value premia are largely explained by exposure of cash flows to profitability, whereas growth stocks' excess returns are largely explained by cash flow exposure to the real rate. With respect to inflation risk, stocks writ large are a store of value, and value stocks are a strong hedge as their dividends move more than one for one with inflation.
Keywords: asset pricing, risk premium, equity risk premium, value risk premium, inflation, business cycle risk, long run
JEL Classification: G12
Suggested Citation: Suggested Citation