Nonlinearities in the Relation Between the Equity Risk Premium and the Term Structure

Abstract

This paper investigates the relation between the conditional expected equity risk premium and the slope of the term structure of interest rates. Theoretically, these variables are linked, the relation may be nonlinear, and negative risk premiums are consistent with equilibrium. Given these implications, we employ a nonparametric estimation technique to document the empirical relation between the risk premium and the slope of the term structure using almost two hundred years of data. Of particular interest, the risk premium is increasing in the term structure slope; however, for either small or negative slopes, the risk premium is much more sensitive to changes in interest rates. In addition, the empirical results imply negative expected equity risk premiums for some inverted term structures. Finally, variations in the risk premium do not appear to be related to variations in the variance of equity returns. We illustrate these features in a stylized consumption-based model, and provide the economic intuition behind the results.