Dynamic Equity Slope

Abstract

The term structure of equity and its cyclicality are key to understand the risks driving equilibrium asset prices. We propose a general equilibrium model that jointly explains four important features of the term structure of equity: (i) a negative unconditional term premium, (ii) countercyclical term premia, (iii) procyclical equity yields, and (iv) premia to value and growth claims respectively increasing and decreasing with the horizon. The economic mechanism hinges on the interaction between heteroskedastic long-run growth--which helps price long-term cash flows and leads to countercyclical risk premia--and homoskedastic short-term shocks in the presence of limited market participation--which produce sizeable risk premia to short-term cash flows. The slope dynamics hold irrespective of the sign of its unconditional average. We provide empirical support to our model assumptions and predictions.

Keywords: term structure of equity, dynamics, general equilibrium, expected growth volatility

JEL Classification: D51,D53,E30,G10, G12