Intermediary-Based Equity Term Structure

Abstract

New empirical facts show that equity term premium is counter-cyclical, while the term structure of equity yield is pro-cyclical and switches sign between expansions and recessions. We decompose the term structure of equity yield into an equity term premium and a mean reversion component about the expected changes in future yields to understand this seemingly contradictive evidence. Although the first component is counter-cyclical, we show the second mean reversion component dominantly drives the pro-cyclical fluctuations of the overall equity yield curve. We propose a financial intermediary-based asset pricing model to quantitatively account for both facts simultaneously. In our model, the mean reversion component is endogenously driven by the time-varying tightness of the intermediaries' leverage constraint. We demonstrate that the cyclical pattern of equity term structure imposes a strong discipline on the speed of mean reversion of discount rate for any standard asset pricing models. In the standard calibration of long-run risks model Bansal and Yaron (2004) and habit model Campbell and Cochrane (1999), the mean reversion speed of discount rate is too slow to account for a negative correlation between equity yield curve and equity term premium.