The dynamics of bond yields and the stock index - with an application to the UK stock and bond market

Abstract

The dynamics of nominal bond yields and the stock index are modelled within a continuous-time general equilibrium economy. Closed-form solutions are provided for both the term structure of nominal interest rates and the equilibrium value of the stock index where the value of the stock index is determined as the present value of future aggregate dividends. Preferences towards risk have crucial implications for the comovements of the stock index and bond yields since the degree of risk aversion determines whether the stock index is positively or negatively related to the real interest rate. As an application, the model is calibrated based on monthly data from the UK in the period from January 1979 to October 1996 in order to facilitate an analysis of what drives the movements of the term structure of nominal interest rates and what drives the (negative) correlation between the stock index and bond yields.