Stock and Bond Pricing in an Affine Economy

Abstract

This article provides a stochastic valuation framework for bond and stock returns that builds on three different pricing traditions: affine models of the term structure, present-value pricing of equities, and consumption based asset pricing. Our model provides a more general application of the affine framework in that both bonds and equities are priced in a consistent fashion. This pricing consistency implies that term structure vairables help price stocks while stock price fundamentals help price the term structure. We illustrate our model by considering three examples that are similar in spirit to well-known pricing models that fall within our general framework: a Mehra and Prescott (1985) economy, a present value model similar to Campbell and Shiller (1988), and a model with stochastic risk aversion similar to Campbell and Cochrane (1999). The empirical performance of our models is explored, with a particular emphasis on return predictability.