Equity Valuation Under Stochastic Interest Rates

Marco Realdon

Discussion Papers from Department of Economics, University of York

Abstract: This paper presents an equity valuation model that employs risk-neutral valuation under stochastic interest rates along the lines of Ohlson and Feltham (1999). Closed form valuation formulae for equities are presented in a discrete time setting whereby the short term interest rate is modelled by a quadratic term structure model. Earnings are driven by mean reverting return on equity (ROE). The term strcture of interest rates, and in particular the variance of the future short rates, is found to be a primary dterminant of equity value tat has been largely overlooked by the previous equity valuation literature. Equity value decreases in the correlation between the short interest rate and ROE and can be very sensitive to such correlation when the ROE process is very persistent. This suggests that equity value dreceases in the degree of pro-cyclicality of the firm's profitability.

Keywords: Equity valuation; residual income valuation; stochastic interest rates; quadratic term structure model in discrete time; mean reverting return on equity (search for similar items in EconPapers)
JEL-codes: G12 G13 M41 (search for similar items in EconPapers)
Date: 2006-06
New Economics Papers: this item is included in nep-acc, nep-cfn, nep-fin and nep-fmk
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