Working Paper: NBER ID: w12912
Authors: Mariano M. Croce; Martin Lettau; Sydney C. Ludvigson
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.
Keywords: Asset Pricing; Longrun Risk; Term Structure; Equity Risk Premium
JEL Codes: E44; G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| full information model (D83) | upward sloping term structure (E43) |
| bounded rationality limited information model (D80) | sizable equity risk premium (G12) |
| bounded rationality limited information model (D80) | downward sloping term structure (E43) |
| bounded rationality limited information model (D80) | contamination of long-run estimates by short-run shocks (C22) |
| contamination of long-run estimates by short-run shocks (C22) | downward sloping term structure (E43) |
| full information paradigm (D83) | high equity risk premium (G12) |
| high equity risk premium (G12) | upward sloping term structure (E43) |
| long-run component in dividend growth (G35) | source of insurance (G52) |