Why is long-horizon equity less risky?
Subtitle: a duration-based explanation of the value premium
By: Martin Lettau, Jessica Wachter.
Contributors: Wachter, Jessica.; National Bureau of Economic Research.
Series: NBER working paper series ;; working paper 11144; Working paper series (National Bureau of Economic Research : Online) ;; working paper no. 11144.
Publisher: National Bureau of Economic Research
Published: 2005
Place of publication: Cambridge, MA
Language: eng
Format: Electronic resource
Subjects: Stocks -- Mathematical models.; Rate of return -- Mathematical models.; Corporations -- Valuation -- Mathematical models.; Risk -- Mathematical models.; Investments -- Mathematical models
Description: "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"--National Bureau of Economic Research web site.
Notes: Includes bibliographical references.
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