Comment on ‘A Wealth Based Explanation for Earnings Conservatism’ Get access Simon Benninga Simon Benninga Search for other works by this author on: Oxford Academic Google Scholar Review of Finance, Volume 5, Issue 3, 2001, Pages 351–352, https://doi.org/10.1023/A:1013834904395 Published: 01 December 2001

The paper examines the allocation of consumption and investment in a three-date binomial model in order to determine the sign of the real term structure premium in general equilibrium. When production functions are concave, markets are complete, and future production possibilities are the same irrespective of which state of the world occurs, the term structure premium will be positive. In incomplete markets, constant or increasing absolute risk aversion is sufficient to guarantee a positive term structure premium, although in the (more likely) case of decreasing absolute risk aversion a negative premium cannot be ruled out.

We show that there exist separate security market lines (SMLs) for debt and equity securities in an equilibrium with differential taxation of debt and equity. We characterize the conditions under which these SMLs have the same price of risk (with different intercepts) and the conditions under which the tax effect of leverage is linear in debt value as in the adjusted present value method. We explore the implications of our results for cost of capital calculations: How to calculate the cost of capital for debt and equity and how to unlever betas correctly accounting for differential taxation.

Higher relative risk aversion is associated with higher risk premiums only if the riskiness of output is exogenous. When consumers can affect the variability of output, the market risk premium may well decrease as the relative risk aversion increases. With constant relative risk aversion and linear production functions, the ratio of the market risk premium to the standard deviation of the market is constant and independent of the relative risk aversion. Copyright 1991 by American Economic Association.

Higher relative risk aversion (RRA) is associated with higher risk premiums only if the riskiness of output is exogenous. When consumers can affect the variability of output, the market risk premium may well decrease as the RRA increases. With constant relative risk aversion and linear production functions, the ratio of the market risk premium to the standard deviation of the market is constant and independent of the RRA.

This paper examines the relation between nominal and real interest rates, and the nominal and real term structure under uncertainty. We show that two separate risk terms cause the Fisher theorem to fail. One risk term is related only to the variability of money prices, while the other is related to the purchasing power riskiness of the nominal bond. Monetary policy can affect the value of both these risk terms. We also show that the pure expectations hypothesis of the term structure fails for both real and nominal bonds because of risk premia. Even if the economy is neutral with respect to monetary policy, monetary policy can alter the nominal term structure.