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The Cross-Section and Time-Series of Stock and Bond Returns

Authors: Nieuwerburgh, Stijn Van
Lustig, Hanno N.
Koijen, Ralph S. J.
Issue Date: 9-Jan-2012
Series/Report no.: FIN-11-048
Abstract: We propose a three-factor model that jointly prices the cross-section of returns on portfolios of stocks sorted on the book-to-market dimension, the cross-section of government bonds sorted by maturity, and time series variation in expected bond returns. The main insight is that innovations to the nominal bond risk premium price the book-to-market sorted stock portfolios. We argue that these innovations capture business cycle risk and show that dividends of the highest book-to-market portfolio fall substantially more than those of the low book-to-market portfolio during NBER recessions. We propose a structural model that ties together the nominal bond risk premium, the cross-section of book-to-market sorted stock portfolios, and recessions. This model is quantitatively consistent with the observed value, equity, and nominal bond risk premia.
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