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

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

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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12912.

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Date of creation: Feb 2007
Date of revision:
Handle: RePEc:nbr:nberwo:12912
Note: AP
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