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On the Systematic Volatility of Unpriced Earnings Shocks

54 Pages Posted: 17 Mar 2012 Last revised: 23 Dec 2013

Timothy C. Johnson

University of Illinois at Urbana-Champaign

Jaehoon Lee

University of New South Wales (UNSW)

Date Written: September 5, 2013

Abstract

Some important puzzles in macro finance can be resolved in a model featuring systematically varying volatility of unpriced shocks to firms' earnings. In the data, the correlation between corporate debt and stock market valuations is low. The model accounts for this via the opposing effect of unpriced earnings risk on levered debt and equity prices. The model also explains the low (or nonexistent) risk-reward relation for the market portfolio of levered equity via the opposing effects of unpriced and priced uncertainty (both components of stock volatility) on the levered equity risk premium. Versions of the model calibrated to empirical measures of both types of fundamental risk can quantitatively substantiate these explanations. Variation in residual earning dispersion accounts for a significant fraction of observed disagreement between debt and equity valuations, and of realized stock volatility. The implication that the two components of risk should forecast the levered equity risk premium with opposite signs is also supported in the data. The results are a notable advance for risk-based asset pricing.

Keywords: credit spreads, equity premium, volatility components

JEL Classification: G12

Suggested Citation

Johnson, Timothy C. and Lee, Jaehoon, On the Systematic Volatility of Unpriced Earnings Shocks (September 5, 2013). Journal of Financial Economics (JFE), Forthcoming; AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2022734 or http://dx.doi.org/10.2139/ssrn.2022734

Timothy C. Johnson (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

Jaehoon Lee

University of New South Wales (UNSW) ( email )

Sydney, NSW 2052
Australia

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