Why is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium

Martin Lettau, Jessica Wachter

NBER Working Paper No. 11144
Issued in February 2005
NBER Program(s):   AP

This paper proposes a dynamic risk-based model that captures the high expected returns on value stocks relative to growth stocks, and the failure of the capital asset pricing model to explain these expected returns. To model the difference between value and growth stocks, we introduce a cross-section of long-lived firms distinguished by the timing of their cash flows. Firms with cash flows weighted more to the future have high price ratios, while firms with cash flows weighted more to the present have low price ratios. We model how investors perceive the risks of these cash flows by specifying a stochastic discount factor for the economy. The stochastic discount factor implies that shocks to aggregate dividends are priced, but that shocks to the time-varying price of risk are not. As long-horizon equity, growth stocks covary more with this time-varying price of risk than value stocks, which covary more with shocks to cash flows. When the model is calibrated to explain aggregate stock market behavior, we find that it can also account for the observed value premium, the high Sharpe ratios on value stocks relative to growth stocks, and the outperformance of value (and underperformance of growth) relative to the CAPM.

download in pdf format
   (923 K)

email paper

This paper is available as PDF (923 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w11144

Published: Martin Lettau & Jessica A. Wachter, 2007. "Why Is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium," Journal of Finance, American Finance Association, vol. 62(1), pages 55-92, 02. citation courtesy of

Users who downloaded this paper also downloaded these:
Santos and Veronesi w11816 Cash-Flow Risk, Discount Risk, and the Value Premium
Chen, Petkova, and Zhang w12183 The Expected Value Premium
Novy-Marx w15940 The Other Side of Value: Good Growth and the Gross Profitability Premium
Campbell, Polk, and Vuolteenaho w11389 Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns
van Binsbergen, Fernández-Villaverde, Koijen, and Rubio-Ramírez w15890 The Term Structure of Interest Rates in a DSGE Model with Recursive Preferences
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us