What Drives Equity Prices: Short- or Long-Run Risk?

50 Pages Posted: 12 Feb 2018 Last revised: 9 Aug 2019

See all articles by Christian Dorion

Christian Dorion

HEC Montreal

Adelphe Ekponon

University of Cambridge - Judge Business School

Alexandre Jeanneret

HEC Montréal

Date Written: May 4, 2018

Abstract

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

Dorion, Christian and Ekponon, Adelphe and Jeanneret, Alexandre, What Drives Equity Prices: Short- or Long-Run Risk? (May 4, 2018). Available at SSRN: https://ssrn.com/abstract=3116235 or http://dx.doi.org/10.2139/ssrn.3116235

Christian Dorion

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada
5143401522 (Phone)
5143405632 (Fax)

HOME PAGE: http://neumann.hec.ca/pages/christian.dorion/

Adelphe Ekponon (Contact Author)

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

HOME PAGE: http://sites.google.com/site/adelpheekponon/

Alexandre Jeanneret

HEC Montréal ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

HOME PAGE: http://www.alexandrejeanneret.net

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