The Risk-Free Rate’s Impact on Stock Returns with Representative Fund Managers

Abstract: In this thesis, the risk-free rate’s impact on stock market excess returns was examined. Firstly, theoretical arguments were made for that a low risk-free rate might lower the excess return on the stock market, since this increases the incentive for fund managers to increase variance of returns. Under the assumption that fund managers affect the preferences of the representative investor, propositions regarding stock returns and the risk-free rate were made. Using the time series of stochastic volatility risk premium estimates created by Bollerslev, Gibson and Zhou’s (2011), it was tested if investor risk aversion is lower when the risk-free rate is low. The risk-free rate’s impact on the cross-section of stock returns was tested through the same methodology used by Black, Jensen, Scholes (1972) with independent variables linked to the risk-free rate added. Support for lower risk aversion during periods of a low risk-free rate was found. In opposite to the proposition regarding the cross-section of stock returns, the tests suggest that excess returns for all portfolios are higher when the risk-free rate is low.