Content area
Full Text
Empirical equity duration is a useful measure.
(ProQuest-CSA LLC: ... denotes formulae omitted.)
The association between interest rate changes and stock returns has been of enduring interest to investors. Investors, the financial press, and even the popular press frequently look to Federal Reserve policy reflected in interest rate changes. U.S. and global stock and bond markets actually experienced significant changes in response to nuances in the language of Former Fed Chairman Alan Greenspan and other prominent Fed officials.
At the same time, there have been analytical developments related to fixed-income securities that can be used to measure the effect of interest rate changes on stocks. Specifically, an alternative specification of duration, a widely used measure of interest rate sensitivity for bonds, can be applied to common stock.
The notion of duration for fixed-income securities has been around since the seminal work of Macaulay [1938]. Then 30 years later, Fisher and Weil [1971] applied the concept of duration to bond portfolio immunization. Since then Hopewell and Kaufman [1973] derived the relation between modified Macaulay duration and interest rate sensitivity for option-free bonds that has become a major tool in bond portfolio management.
Recent work using effective duration has expanded the measurement of interest rate sensitivity for bonds with embedded options as discussed in Fabozzi, Buetow, and Johnson [2001], Dunetz and Mahoney [1988], and Fabozzi, Pitts, and Dattatreya [1997]. A major requirement for using effective duration is an asset pricing model that can derive an estimate of prices, given a change in interest rates. For many assets whose pricing is influenced by interest rate changes (real estate, mortgage-backed securities, and common stocks), it is not possible to derive a meaningful mathematical price estimate when interest rates change. It is not possible to estimate price accurately for these assets because other variables beyond interest rates also affect the valuation of these assets.
In the case of common stock, these other variables include earnings growth or the availability of growth options (see Hevert, McLaughlin, and Taggart [1998]). Research has suggested we estimate the interest rate sensitivity of these assets using empirical duration, which is based upon the historical relation between asset price changes and interest rate changes. Examples of studies using empirical duration include Leibowitz [1987] and Cornell...