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




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    • Lettau is at the Stern School of Business at New York University. Wachter is at the Wharton School at the University of Pennsylvania. The authors thank Andrew Abel, Jonathan Berk, John Campbell, David Chapman, John Cochrane, Lars Hansen, Leonid Kogan, Sydney Ludvigson, Anthony Lynch, Stijn Van Niewerburgh, an anonymous referee, and seminar participants at the 2004 National Bureau of Economic Research Summer Institute, the 2005 Society of Economic Dynamics meetings, the 2005 Western Finance Association Meetings, Duke University, New York University, Pennsylvania State University, University of British Columbia, University of Chicago, University of Pennsylvania, and Yale University for helpful comments.


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.