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Stock price, risk-free rate and learning

Zhang, Tongbin (2014): Stock price, risk-free rate and learning.

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Abstract

The comovement between stock and short-term bond markets in US data shows to be weak measured by the correlation between stock price-dividend ratio and risk-free rate, as well as the statistics coming from variance decomposition approach. Understanding the weak comovement is important for both investors and policy makers. We show that several rational expectation asset pricing models that match stock market volatility are inconsistent with the weak comovement because stock prices there are fundamental driven. To explain the weak comovement, we present a small open economy model with "Internally Rational" agents, who optimally update their subjective beliefs on stock prices given their own model. Compared with risk-free rate's variation, agents' subjective beliefs are central in generating stock price volatility. When testing our model using the method of simulated moments, we find that it can simultaneously match the basic stock and short-term bond market facts, and the weak comovement between two markets quantitatively.

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