Stock and bond returns with Moody Investors

We present a tractable linear model for the simultaneous pricing of stock and bond returns that incorporates stochastic risk aversion In this model analytic solutions for endogenous stock and bond prices and returns are readily calculated After estimating the parameters of the model by the general method of moments we investigate a series of classic puzzles of the empirical asset pricing literature In particular our model is shown to jointly accommodate the mean and volatility of equity and long term bond risk premia as well as salient features of the nominal short rate the dividend yield and the term spread Also the model matches the evidence for predictability of excess stock and bond returns However the stock-bond return correlation implied by the model is somewhat higher than that in the data (C) 2010 Elsevier B V All rights reserved