In asset pricing, a macroeconomic risk is an event that can influence most financial assets. We measure it through country-level variables like the gross domestic product, aggregate consumption, interest rates, inflation, and exchange rate. Many studies have explored the role of these macro-variables in explaining a firm or a country’s financial decisions and on the pricing of stocks, corporate and sovereign bonds. They point out the critical role of macroeconomic risk in explaining the dynamics of asset prices, as opposed to the canonical CAPM type of risk. Among these works, consumption-based models are one of the most popular.
There are (at least) two sources of macroeconomic risk into consumption dynamics: short-run risk originating from temporary disturbance or Brownian shocks and long-run risk characterised by low-frequency changes in consumption growth rate and volatility. A rational investor who cares not only about shocks to her consumption but also the arrival and length of bad economic periods should incorporate these two sources of risk into financial assets valuation. Current research examines either the first or second source, making it impossible to understand their relative contribution or the role of the long-run risk.
We derive and study in models that combine both sources of risk, how long-run risk can improve our understanding of various phenomena in finance.
First, we quantify the asset pricing implications of short- and long-run risks when shareholders can account for them when determining the firm’s capital structure and default decisions. We show that in a model with short-run risk only, firms’ decisions are barely affected whereas, with long-run risk only, optimal decisions are significantly altered and close to empirical observations. Interestingly, when both sources are combined, predictions are close to the long-run risk only model. We measure the contribution of each source in risk premia and show that long-run risk accounts for at least two-thirds of the expected returns. We also show how their relative importance varies across firms regarding their degree of exposure to each source.
Second, we examine the role of long-run risk in explaining cross-sectional differences in the cost of equity in a model in which firms can adjust their governance practices and have different policies over time. The model predicts that firms with laxer governance practices in recession vs. expansion periods experience higher fluctuations in their stock price (higher reduction in stock value in recession compared to a model with no agency conflicts), leading to a higher average cost of equity. We find strong empirical evidence for these predictions. Most studies focus on the average corporate governance quality, whereas we explore asset pricing implications of its time-varying nature.
Finally, we develop a model to measure sovereign bond risk premia coming from changes in global macroeconomic conditions (long-run risk). We also address this question empirically. In our calibration, 90% of the total sovereign bond premium comes from long-run risk. We find that sovereign bonds of countries that are more sensitive to shifts in the global business cycle deliver higher expected excess returns.