Corporate Earnings and the Equity Premium

Economic shocks affect corporate cash flows far more than they do aggregate consumption. We examine the asset-pricing implications of corporate sensitivity to shocks using a continuous-time representative agent framework in which earnings are a stochastic fraction of total consumption. We provide closed-form solutions for equity values when earnings and consumption follow exponential-affine jump-diffusion processes. Calibrating the model to historical data, we show that the extreme sensitivity of corporate cash flows to shocks dramatically increases the equity premium. The model implies realistic values for the equity premium given modest levels of risk aversion and generates levels of equity volatility consistent with those experienced by the stoc