NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Investor Information, Long-Run Risk, and the Term Structure of Equity

Mariano M. Croce, Martin Lettau, Sydney C. Ludvigson

NBER Working Paper No. 12912
Issued in February 2007
NBER Program(s):   AP

We study the role of information in asset pricing models with long-run cash flow risk. When investors can distinguish short- from long-run consumption risks (full information), the model generates a sizable equity risk premium only if the equity term structure slopes up, contrary to the data. In general, the short- and long-run components are unidentified. We propose a sparsity-based bounded rationality model of long-run risk that is both parsimonious and fully identified from historical data. In contrast to full information, the model generates a sizable market risk premium simultaneously with a downward sloping equity term structure, as in the data.

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This paper was revised on August 22, 2014

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Document Object Identifier (DOI): 10.3386/w12912

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