NONLINEARITIES IN THE RELATION BETWEEN THE EQUITY RISK PREMIUM AND THE TERM STRUCTURE

This paper investigates the relation between the conditional expected equity risk premium and the slope of the term structure of interest ra tes. Theoretically, these variables are linked, the relation may be no nlinear, and negative risk premiums are consistent with equilibrium. G iven these implications, we employ a nonparametric estimation techniqu e to document the empirical relation between the risk premium and the slope of the term. structure using almost two hundred years of data. O f particular interest, the risk premium is increasing in the term stru cture slope; however, for either small or negative slopes, the risk pr emium is much more sensitive to changes in interest rates. In addition , the empirical results imply negative expected equity risk premiums f or some inverted term structures. Finally, variations in the risk prem ium do not appear to be related to variations in the variance of equit y returns. We illustrate these features in a stylized consumption-base d model, and provide the economic intuition behind the results.