The relation between the equity risk premium and t

Authors: Angelos Kanas

Publish Date: 2008/06/21

Volume: 33, Issue: 2, Pages: 111-

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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 regimedependent 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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