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Reinvestment Risk and the Equity Term Structure

The equity term structure is downward sloping at long maturities. I estimate an Intertemporal Capital Asset Pricing Model (ICAPM) to show that the trade-off between market and reinvestment risk explains this pattern. Intuitively, while long-term dividend claims are highly exposed to market risk, they are good hedges for reinvestment risk because dividend prices rise as expected returns decline, and longer-term claims are more sensitive to discount rates. In the estimated ICAPM, reinvestment risk dominates at long maturities, inducing relatively low risk premia on long-term dividend claims. The model is also consistent with the equity term structure cyclicality and the upward-sloping bond term structure.

Author - Andrei S Gonçalves
Journal - Journal of Finance

Source -