Overconfidence, Differences in Beliefs and The Equity Premium Term Structure

Abstract

Empirical studies suggest that the equity premium term structure is downward sloping. By deriving a closed form dividend strips pricing formula in a heterogeneous-agent economy, we show that when some investors are over-pessimistic, typically in a bear market: 1) short-maturity dividend strips have higher risk premium than the aggregate stock market; 2) the volatility term structure of dividend strip prices is downward sloping. These results imply that the slope of equity premium term structure is pro-cyclical. We show that belief dispersion and overconfidence can explain the equity premium term structure and determine the term structure of quantity and price of risks. Intuitively the difference in beliefs towards the short run economic growth allows market shocks to produce wealth distribution fluctuation among pessimists and optimists, increasing short run discount rate and short term risk premium. Meanwhile rational market participants can arbitrage away the pricing errors induced by over-pessimistic investors over time and reduce expected fluctuations in individual wealth gradually, and hence long-term dividend strips have lower volatilities and risk premia.