The Term Structure of Equity Risk Premia

Abstract

We show that the term structure of dividend risk premia and discount rates implied by equity strip yields are downward sloping in recessions and upward sloping in expansions, a finding which is statistically significant and robust across the U.S., Europe, and Japan. Our results are based on the estimation of a regimeswitching dividend growth model, which allows us to characterize not just the conditional but also unconditional moments. Our evidence suggests that the claim about downward sloping equity term structure is rejected from the data. This is an important finding as the standard asset pricing models are not in conflict with the new data on dividend strips. In fact, we show that the standard asset pricing models extended with regime-switching dynamics are able to reconcile these facts.

Keywords: Asset pricing, business cycle phases, dividend strips, equity term structure, regime switching

JEL Classification: D51, E21, G12, G13