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Investor Information, Long-Run Risk, and the Duration fo Risky Assets

Author

Listed:
  • Mariano M. Croce
  • Marin Lettau

    () (NYU)

  • Sydney Ludvigson

Abstract

Value stocks have higher average returns than growth stocks. At the same time, the duration of value stocks' cash flows is considerably shorter than that of growth stocks. We show that when investors can fully distinguish short- and long-run consumption risk components of dividend growth innovations, only exposure to long-run consumption risk generates significant risk premia, implying that high-return value stocks should be long-duration assets, contrary to the historical data. By contrast, when investors observe the change in consumption and dividends each period but not the individual components of that change (limited information), exposure to short-run risk can generate large risk premia, implying that value stocks become short-duration assets while growth stocks are long-duration assets, as in the data. The limited information specifications we explore are not only consistent with the cash flow duration properties of value and growth stocks, they also explain the observed value premium, the higher Sharpe ratios of value stocks, the failure of the CAPM to account for the value premium, and the success of the HML factor of Fama and French (1993) in explaining the value premium.

Suggested Citation

  • Mariano M. Croce & Marin Lettau & Sydney Ludvigson, 2006. "Investor Information, Long-Run Risk, and the Duration fo Risky Assets," 2006 Meeting Papers 628, Society for Economic Dynamics.
  • Handle: RePEc:red:sed006:628
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    File URL: http://repec.org/sed2006/up.22793.1140024472.pdf
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    References listed on IDEAS

    as
    1. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    2. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
    3. John Lintner, 1965. "Security Prices, Risk, And Maximal Gains From Diversification," Journal of Finance, American Finance Association, vol. 20(4), pages 587-615, December.
    4. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 1-47, February.
    5. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
    6. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-969, July.
    7. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    8. Cornell, Bradford, 1999. "Risk, Duration, and Capital Budgeting: New Evidence on Some Old Questions," The Journal of Business, University of Chicago Press, vol. 72(2), pages 183-200, April.
    9. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
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    Citations

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    Cited by:

    1. Jules van Binsbergen & Michael Brandt & Ralph Koijen, 2012. "On the Timing and Pricing of Dividends," American Economic Review, American Economic Association, vol. 102(4), pages 1596-1618, June.
    2. Andries, Marianne & Eisenbach, Thomas M. & Schmalz, Martin C., 2014. "Horizon-dependent risk aversion and the timing and pricing of uncertainty," Staff Reports 703, Federal Reserve Bank of New York, revised 01 Mar 2018.
    3. George M. Constantinides & Anisha Ghosh, 2011. "Asset Pricing Tests with Long-run Risks in Consumption Growth," Review of Asset Pricing Studies, Oxford University Press, vol. 1(1), pages 96-136.
    4. Mariano M. Croce, 2006. "Welfare Costs, Long Run Consumption Risk, and a Production Economy," 2006 Meeting Papers 582, Society for Economic Dynamics.
    5. Ina Simonovska & Espen Henriksen, 2013. "Time-Varying Risk Premia and Capital Flows to Developing Countries," 2013 Meeting Papers 1258, Society for Economic Dynamics.
    6. Thomas Eisenbach & Martin Schmalz & Marianne Andries, 2015. "Asset Pricing with Horizon-Dependent Risk Aversion," 2015 Meeting Papers 1069, Society for Economic Dynamics.
    7. repec:oup:revfin:v:21:y:2017:i:3:p:945-985. is not listed on IDEAS
    8. John H. Cochrane, 2017. "Macro-Finance," Review of Finance, European Finance Association, vol. 21(3), pages 945-985.

    More about this item

    Keywords

    Information; Long-Run Risk; Value Premium;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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