Investor Information, Long-Run Risk, and the Term Structure of Equity

We study the role of information in asset-pricing models with long-run cash flow risk. When investors can distinguish short- from long-run consumption risks (full information), the model generates a sizable equity risk premium only if the equity term structure slopes up, contrary to the data. In gen...

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Bibliographic Details
Published in:The Review of financial studies 2015-03, Vol.28 (3), p.706-742
Main Authors: Croce, Mariano M., Lettau, Martin, Ludvigson, Sydney C.
Format: Article
Language:English
Subjects:
Asset pricing
Cash flow
Consumption
Equity
Investments
Investors
Rationality
Risk premiums
Sparsity
Studies
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Summary:We study the role of information in asset-pricing models with long-run cash flow risk. When investors can distinguish short- from long-run consumption risks (full information), the model generates a sizable equity risk premium only if the equity term structure slopes up, contrary to the data. In general, the short- and long-run components are unidentified. We propose a sparsity-based bounded rationality model of long-run risk that is both parsimonious and fully identified from historical data. In contrast to full information, the model generates a sizable market risk premium simultaneously with a downward-sloping equity term structure, as in the data.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhu084