Abstract: This paper uses the term structure of interest rates
to explain the variations of stock prices and stock returns. It shows
that interest rates have an important impact on stock returns,
especially at long horizons. The hypothesis that expected stock
returns move one-for-one with ex ante interest rates, which has been
rejected strongly in other studies using short horizon data, is
supported by long horizon data. The paper proposes, for the first
time, a single measure---the present value of forward interest
rates---to summarize the information of the term structure that is
useful in characterizing the comovements of the equity market and the
bond market, and finds that such a single measure explains a
significant part of variation in dividend-price ratios. The paper also
suggests that the high volatility of the stock market is related to
the high volatility of long-term bond yields and may be accounted for
by changing forecasts of discount rates. The findings of this paper
are quite different from the typical findings of the previous work and
may provide a reasonable economic explanation for the predictability
of long-horizon stock returns.
Keywords: Comovement, stock market, term structure
Full paper (216 KB PDF)
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