Term structure of risk in expected returns

Abstract

Return predictability reveals economic variables that drive expected returns. Alternative economictheories relate fluctuations in predictive variables to different sources of risk. I develop an empiricalapproach that exploits these observations and measures how economically interpretable shockspropagate in the term structure of expected buy-and-hold returns. Shock propagation patternsconstitute term structure of risk in expected returns whose shape and level serve as informativemoments to test competing equilibrium theories of return predictability. As an application, Iexamine sources of stock return predictability. I find that equilibrium shocks in the long-run meanof the variance of consumption growth can justify the level and the shape of the term structure ofexpected stock returns, in contrast to consumption disasters or long-run risk.