Term Structure(s) of the Equity Risk Premium
89 Pages Posted: 19 Mar 2018
Date Written: March 19, 2018
By simultaneously using dividend and variance swap data, we show how the term structure of the equity risk premium varies over time and how its shape is affected by liquidity risk premia. The term structure is always positively sloped, while funding liquidity premia and betas explain the high unconditional returns for all dividend claims. Alphas for short-dated dividend claims become negative, whereas alphas for long-dated claims seem to be positive. The term structure slope varies positively with the market risk premium, but it is never negative relative to the first contract – due to the nearly zero risk premium in the first maturity – and rarely hump-shaped in some empirical models. We demonstrate how the maturity term structure – the risk premium for dividend strips with different maturities – is connected to both the horizon term structure – linked to the variance swap term structure – and various funding liquidity measures. The risk premium is on average increasing with investment horizon, while the 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 risk premium depends primarily on the short-horizon risk premium, implying that short-horizon investors are the marginal ones. All our results hold in the US, the UK, Europe and Japan. All these facts are consistent with, for instance, a long-run risk model with jump risks.
Keywords: Equity Risk Premium, Term Structure, Dividend Swaps, Variance Swaps, Liquidity
JEL Classification: G10, G12, G13, G23
Suggested Citation: Suggested Citation