What Drives the Expected Return on a Stock: Short-Run or Long-Run Risk?

Abstract

This paper addresses this question with an asset-pricing model featuring endogenous corporate policies. Long-run risk reflects a firm’s profit exposure to slowly-moving expected consumption growth, whereas short-run risk captures the exposure to frequent unexpected changes in consumption growth. Long-run risk reduces a firm’s optimal leverage while driving most of the equity risk premium. The contribution of short-run risk increases during expansions and for firms with higher idiosyncratic volatility, but remains similar across levels of default risk and systematic volatility. These findings contribute to understanding the expected return on a stock, both over time and in the cross-section.

Keywords: Equity risk premium, long-run risk, short-run risk, capital structure, asset pricing

JEL Classification: G12, G17, E44