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The relation between the equity risk premium and the bond maturity premium in the UK: 1900–2006

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Abstract

Using a rich data set for the UK for over a century, we find that the relation between the equity risk premium and the government bond maturity premium is nonlinear and subject to stochastic regime switching. We identify a regime in which both premia are jointly characterized by low volatility and another regime in which both premia are characterized by high volatility. The occurrence of the high volatility regime chronologically coincides with major changes in the pound exchange rate. The low volatility regime has a higher probability of turning up over two consecutive years than the high volatility regime, but it is not perceived by investors to be an absorbing regime. The lagged maturity premium is a strong predictor of the equity risk premium only in the regime of low volatility. In addition, the lagged equity premium is a predictor of the maturity premium also in the low volatility regime. This result on regime-dependent bidirectional predictability is robust to alternative definitions of the equity premium, and to the inclusion of real interest rate and real growth effects.

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Notes

  1. Other influential studies on the UK stock market predictability include Black and Fraser (1995), Fitzgerald (1992), Clare et al. (1994), O’Hanlon and Steele (2000), Dimson and Marsh (2001), and Dimson et al. (2007). For the USA, Pesaran and Timmermann (2000).

  2. Strictly speaking, long term government bonds are risk free only in the sense that they normally offer a fixed income and the likelihood of default is very small. In all other respects, they are riskier than bills.

  3. The data source for the real interest rate and the real growth rate is the Global Financial Data provider.

  4. The regime switching VAR is a multivariate generalisation of the Hamilton (1989) model. See also, Timmermann (2000).

  5. A VAR with 0 lags was estimated but there was evidence of serial correlation. We have also estimated a second order VAR, but the second order lags were not statistically significant.

  6. Using the usual LR test is problematic because the LR test does not have the standard asymptotic distribution. The problem comes from the fact that under the null hypothesis, some parameters are not identified and the scores are identically zero. To overcome this problem, we employ the non-standard LR bound test proposed by Davies (1987).

  7. Exactly the same results hold for the alternative definition of the equity premium in terms of bonds.

  8. For an extensive analysis of the stock-bond correlations, see Addona and Kind (2006).

  9. These authors found that recessions lead to increases in stock market volatility.

  10. In Tables 5 and 6, the equity risk premium is defined in terms of the Treasury bill yield. Using the alternative definition of the equity premium in terms of the long-term bond yield does not change qualitatively the results. The results are not reported to save space, but are available upon request.

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Authors and Affiliations

  1. Department of Economics, University of Crete, 74100 Rethymnon, Crete, Greece

    Angelos Kanas

  2. IACM-FORTH, 71110 Heraklion, P.O. Box 1385, Crete, Greece

    Angelos Kanas

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  1. Angelos Kanas
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Correspondence to Angelos Kanas.

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Kanas, A. The relation between the equity risk premium and the bond maturity premium in the UK: 1900–2006. J Econ Finance 33, 111–127 (2009). https://doi.org/10.1007/s12197-008-9038-2

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