What Drives Equity Prices: Short- or Long-Run Risk?
50 Pages Posted: 12 Feb 2018 Last revised: 9 Aug 2019
Date Written: May 4, 2018
This paper investigates the relative impact of two fundamental types of systematic risk on equity prices. Equity risk premium is determined in a consumption-based corporate finance model with time-varying macroeconomic conditions. We show that long-run risk, which exposes firm profitability to the slowly-moving business cycle, commands most of the risk premium in recessions. However, during periods of expansions, most of the equity risk premium relates to short-run risk, which arises from the instantaneous covariation between firm cash flows and consumption. These findings are robust to accounting for endogenous capital structure and default policies. An empirical analysis with U.S. firms over the period 1952-2016 provides support for the model predictions.
Keywords: Asset pricing, long-run risk, cross-section of returns, recursive preferences
JEL Classification: G12, G17, E44
Suggested Citation: Suggested Citation