Abstract
We show that nonlinearity in the relation between the equity premium and the slope of the term structure has two dimensions, namely asymmetry between positively and negatively sloped term structures, and regime switching. Asymmetry is uncovered only if volatility regime switching is allowed in equity premium dynamics. Predictive power for the equity premium arises only from the positively sloped term structure, and only in periods of low volatility of the equity premium.
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Notes
Unit root tests are available upon request.
The usual LR test is problematic because it does not have the standard asymptotic distribution. The problem comes from the fact that under the null, some parameters are not identified.
These authors found that recessions are associated with increases in stock market volatility.
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Kanas, A. A note on the relation between the equity risk premium and the term structure. J Econ Finance 34, 89–95 (2010). https://doi.org/10.1007/s12197-008-9069-8
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DOI: https://doi.org/10.1007/s12197-008-9069-8