Working Paper: NBER ID: w10054
Authors: Francis A. Longstaff; Monika Piazzesi
Abstract: Corporate cash flows are highly volatile and strongly procyclical. We examine the asset-pricing implications of the sensitivity of corporate cash flows to economic shocks within a continuous-time model in which dividends are a stochastic fraction of aggregate consumption. We provide closed-form solutions for stock values and show that the equity premium can be represented as the sum of three components which we call the consumption-risk, event-risk, and corporate-risk premia. Calibrating to historical data, we show that the model implies a total equity premium many times larger than in the standard model. The model also generates levels of equity volatility consistent with those experienced in the stock market.
Keywords: corporate earnings; equity premium; asset pricing
JEL Codes: G1; E1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| corporate cash flows (G39) | equity premium (G12) |
| volatility of corporate cash flows (G32) | stock prices (G12) |
| variance of consumption growth (F62) | consumption-risk premium (D11) |
| probability and size of jumps in consumption (D15) | event-risk premium (G14) |
| covariance between consumption growth and corporate fraction (F62) | corporate-risk premium (G39) |
| sensitivity of corporate cash flows to economic shocks (G39) | equity premium (G12) |