Long-Run Cash-Flow and Discount-Rate Risks in the Cross-Section of US Returns

Abstract

This paper decomposes the overall market beta of common stocks into four parts reflecting uncertainty related to the long-run dynamics of stock- specific and market-wide cash flows and discount rates. We employ a discrete time version of Merton’s Intertemporal CAPM to test whether these four sources of risk command different risk prices. The model performs well in pricing average returns on single- and double-sorted portfolios according to size, book-to-market, dividend-price ratios and past risk. It generates high estimates for the explained cross-sectional variation in average returns, lower average pricing errors than the Fama-French three factor model and economically and statistically acceptable estimates for the coefficient of relative risk aversion.CAPM, cash-flow risk, discount-rate risk, asset pricing