Understanding Short and Long-Run Risk Premia

Abstract

This paper studies the predictability of S&P500 returns using short term risk premia as a conditioning variable. We construct dividend prices using futures data and identify short term risk premia by projecting excess returns of dividend claims on their lagged prices. Regression results for forecasting horizons from 1 to 4 quarters show that time variation in short term risk premia captures time variation in index excess returns, albeit with the wrong sign. Counter to the intuition that a high price of risk commands high returns, high risk premia on dividend claims predict low returns on the index. We discuss the extent to which existing asset pricing model are able to generate these patterns of predictability. We find that models with either habit persistence or long run risk are not consistent with these results.

Keywords: equity risk premium, predictability, dividend prices, asset pricing models, term structure

JEL Classification: G10, G12, G13