[16:43 2/2/2015 RFS-hhu084.tex] Page: 706 706–742 Investor Information, Long-Run Risk, and the Term Structure of Equity

We study the role of information in asset-pricing models with long-run cash flow risk. When investors can distinguish short- from long-run consumption risks (full information), the model generates a sizable equity risk premium only if the equity term structure slopes up, contrary to the data. In general, the short- and long-run components are unidentified. We propose a sparsity-based bounded rationality model of long-run risk that is both parsimonious and fully identified from historical data. In contrast to full information, the model generates a sizable market risk premium simultaneously with a downward-sloping equity term structure, as in the data. (JEL G12, G14, G17) We study the role of information in asset-pricing models with long-run cash flow risk. The idea that long-run cash-flow risk can have important affects on asset prices is exemplified by the work of Bansal and Yaron (2004), who show that a small but persistent common component in the time-series processes of consumption and dividend growth is capable of generating large risk premium