DP5951 Stock and Bond Returns with Moody Investors

Author(s):	Geert Bekaert, Eric Engstrom, Steve Grenadier
Publication Date:	November 2006
Keyword(s):	countercyclical risk aversion, equity premium, excess volatility, habit persistence, return predictability, stock-bond return correlation
JEL(s):	E44, G12, G15
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=5951

We present a tractable, linear model for the simultaneous pricing of stock and bond returns that incorporates stochastic risk aversion. In this model, analytic solutions for endogenous stock and bond prices and returns are readily calculated. After estimating the parameters of the model by the general method of moments, we investigate a series of classic puzzles of the empirical asset pricing literature. In particular, our model is shown to jointly accommodate the mean and volatility of equity and long term bond risk premia as well as salient features of the nominal short rate, the dividend yield, and the term spread. Also, the model matches the evidence for predictability of excess stock and bond returns. However, the stock-bond return correlation implied by the model is somewhat higher than in the data.