Corporate Earnings and the Equity Premium

Francis Longstaff and Monika Piazzesi

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

Abstract: Economic shocks affect corporate cash flows far more than they do aggregate consumption. We examine the asset-pricing implications of corporate sensitivity to shocks using a continuous-time representative agent framework in which earnings are a stochastic fraction of total consumption. We provide closed-form solutions for equity values when earnings and consumption follow exponential-affine jump-diffusion processes. Calibrating the model to historical data, we show that the extreme sensitivity of corporate cash flows to shocks dramatically increases the equity premium. The model implies realistic values for the equity premium given modest levels of risk aversion and generates levels of equity volatility consistent with those experienced by the stock

Date: 2002-09-01
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