An equilibrium model of the term structures of bonds and equities

Abstract

We propose an equilibrium model of the term structures of bonds and equities, which has a similar descriptive ability to the reduced form model proposed by Lettau and Wachter (2011) (LW), and yet offers economic implications about preferences and consumption dynamics. The key is to let the parameters of recursive utility depend on state variables of the economy and replicate the stochastic discount factor specified by LW. We show that the model can explain the stylized facts about the various term structures, which, however, requires a high risk aversion, a high consumption volatility, or both. This tension can be alleviated by changing the parameters of the state-dependent preferences in our model.