Value, Momentum, and Short-Term Interest Rates

Abstract

We present a simple two-factor model that helps explaining several CAPM anomalies -- value premium, return reversal, equity duration, asset growth, and inventory growth. The model is consistent with Merton's ICAPM framework and the key risk factor is the innovation on a short-term interest rate -- the Fed funds rate or the T-bill rate. This model explains a large fraction of the dispersion in average returns of the joint market anomalies. Moreover, the model compares favorably with alternative multifactor models widely used in the literature. Hence, short-term interest rates seem to be relevant for explaining several dimensions of cross-sectional equity risk premia.