Horizon-Specific Macroeconomic Risks and the Cross-Section of Expected Returns

Abstract

We decompose the growth rate of industrial production, and its time-varying volatility, into components with dierent degrees of persistence, and we study the price of risk associated with each of these components’ innovations. We document that, for both mean and volatility, only those uctuations with half-life larger than four years are priced in the cross-section of individual stocks. A standard deviation increase in exposure to long-run macroeconomic growth shocks increases expected returns by 2.5% annually, whereas exposures to long-run volatility innovations command a negative premium of 1:6% per standard deviation. Each of the two proposed measure of macroeconomic risk, the long-run comovement between returns and shocks in macroeconomic growth and the long-run comovement between returns and shocks in the volatility, jointly prices the cross-section of returns on portfolios of stocks sorted on various dimensions (book-to-market, size and past returns) along with the crosssection of government bonds sorted by maturity. Our new evidence resuscitates a central role for business cycle and medium-term cycle (see Comin and Gertler, 2006) aggregate risk as a key determinant of equilibrium asset prices.