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

  • Jessica Wachter
  • Martin Lettau

We propose a dynamic risk-based model that captures the value premium. Firms are modeled as long-lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM. Copyright 2007 by The American Finance Association.

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Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 302.

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Date of creation: 2005
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Handle: RePEc:red:sed005:302
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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