Investor information, long-run risk, and the term structure of equity

Mariano Max Croce, Martin Lettau, Sydney C. Ludvigson

    Research output: Contribution to journalArticle

    Abstract

    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.

    Original languageEnglish (US)
    Pages (from-to)706-742
    Number of pages37
    JournalReview of Financial Studies
    Volume28
    Issue number3
    DOIs
    StatePublished - Mar 1 2015

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    Keywords

    • G12
    • G14
    • G17

    ASJC Scopus subject areas

    • Accounting
    • Finance
    • Economics and Econometrics

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