The Analysis Of The Relationship Between Risk Premium And The Term Structure Of Interest Rate

Theoretically, there is a kind of relationship between equity risk premium and the term structure of interest rates. Economists have done a lot of research which prove a positive relation between the two variables, while Boudoukh, Richardson and Whitelaw issued an article on Management Science in 1997, which investigates the relation between the conditional expected equity risk premium and the slope of the term structure of interest rates. They find out the relation between the two variables is nonlinear, and 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.Main components research finds out that horizontal factor, slope and curvature can explain 96%change of American term structure of interest rate (Litterman and Scheinkman,1991), while Campbell (1987), Fama and French (1989) and Chen (1991) emphasize the impact of term premium on the risk premium. So in this article, we would analyze the relation between term premium and the risk premium. Beyond this, we would also check up the relation between the horizontal factor of term structure of interest rate and the risk premium.This paper investigates the linearity and nonlinearity between equity risk premium and the term structure of interest rates based on dates of Shanghai Stock Exchange. For a better illustration, I divide the population sample into three phases, and the time points are September of 1999 and the December of 2007, which based on trend of risk premium and the significant events during the population sample. And then we apply some common linear and nonlinear methods to analyze the relation between risk premium and term structure of interest rate.Many researches have been done to analyze the factors of risk premium domestically, but seldom of them refer to the term structure of interest rate. However, it has been proved that there is a prominent relationship between risk premium and the term structure of interest rate. The main purpose of this article is to investigate the relationship between risk premium and the term structure of interest rate by Chinese data, and to analyze if the term structure of interest rate could be a good timing index when people invest in the stock market.