Interest Rate Variables

1. Term premium (yield on long-term bonds minus yield on short-term bonds)

2. Risk premium (yield on low-rated debt minus yield on high-rated debt)

The proportion of long-term return that can be explained by these variables is quite high, Fama and French [80] report that 25% of the returns on a value and equally weighted market index over two to four years can be explained by past dividends/price. Furthermore, the sign is positive: a high dividend over price (low level of price) implies high returns. Similarly, Campbell and Shiller [32] find that earnings/price where earnings are averaged over 30 years can explain more than 57% of the yearly returns on a market index.

In a later article Fama and French [82] find that dividend/price plus the term and risk premiums explain a significant proportion of the returns not only for the aggregate stock market index but also for an index of small stock returns, and indexes of high-and low-grade bonds. Furthermore, they find that the effect of dividend over price and risk spread bear a logical relationship to the return on the different instruments. For example, an increase in dividend/price predicts a greater increase in return for small stocks compared to large stocks, stocks compared to bonds, and low-grade debt compared to high-grade

Finally, Harvey [114] finds that the S&P dividend/price and the U.S. term structure variables predict long-term returns on portfolios of foreign stocks.

TEe greatest amount ol research in finance has been devoted to the effect of an announcement on share price. These studies are known as "event studies." Initially event studies were undertaken to examine whether markets were efficient, in particular, how fast the information was incorporated in share price.

For example, when a firm announces earnings will be much larger than expected, will this news be reflected in share price the same day or over the next week? Dozens of studies confirmed that share prices reacted rapidly to announcements, and in expected ways where the direction of the price change and the likely impact were clear. Consequently, many authors accept that information is rapidly incorporated in share price and use event debt.


ANNOUNCEMENT AND Pi studies to determine what information is reflected in price and, if its impact is unclear, to determine whether the announcement is good or bad news.

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