Horizon Bias and the Term Structure of Equity Returns

61 Pages Posted: 14 Feb 2019 Last revised: 22 Apr 2020

See all articles by Stefano Cassella

Stefano Cassella

Tilburg University- School of Economics and Management

Benjamin Golez

University of Notre Dame

Huseyin Gulen

Purdue University - Krannert School of Management

Peter Kelly

University of Notre Dame

Date Written: March 31, 2020

Abstract

Ample evidence suggests that individuals are overly optimistic about future outcomes. But does the length of a particular forecast horizon affect optimism levels? In this paper, we extend Brunnermeier and Parker’s (2005) optimal expectations framework to a multi-period model, which casts the novel prediction that optimism grows with the forecast horizon. We provide empirical evidence that forecasters exhibit horizon bias when making predictions about a wide variety of macroeconomic variables, in the United States and abroad. Using analysts’ earnings forecasts, we also confirm the presence of a horizon bias in the stock market. We then argue that the horizon bias can help explain the puzzling time-series variation in the term structure of equity returns. Consistent with the intuition from a simple present-value model, we find that periods of above-average horizon bias are associated with negative term premia, whereas periods of below average horizon bias are associated with positive term premia. Finally, we explore our model’s implication
that the horizon bias should increase with the skewness of future outcomes. We confirm that the level of horizon bias in the stock market correlates with the market’s implied skewness. We further find that the interaction between horizon bias and skewness generates strong and robust forecasts of future equity term premia.

Keywords: term structure of equities, extrapolation, optimism bias

Suggested Citation

Cassella, Stefano and Golez, Benjamin and Gulen, Huseyin and Kelly, Peter, Horizon Bias and the Term Structure of Equity Returns (March 31, 2020). Available at SSRN: https://ssrn.com/abstract=3328970 or http://dx.doi.org/10.2139/ssrn.3328970

Stefano Cassella

Tilburg University- School of Economics and Management ( email )

Professor de Moorplein 521
Tilburg, 5037
Netherlands

Benjamin Golez

University of Notre Dame ( email )

256 Mendoza College of Business
Notre Dame, IN 46556-5646
United States
(574) 631-1458 (Phone)

HOME PAGE: http://business.nd.edu/BenGolez/

Huseyin Gulen

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

Peter Kelly (Contact Author)

University of Notre Dame ( email )

251 Mendoza
South Bend, IN 46637
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
112
Abstract Views
774
rank
265,025
PlumX Metrics