The Term Structure of Returns: Facts and Theory
In this paper, the authors summarize the basic facts about the term structure of returns in various asset classes and discuss new theories that have been proposed to explain some of these facts. The authors find that short-term equity claims, or dividend strips, have higher average returns and Sharpe ratios than the aggregate stock market. They connect the properties of the term structure of equity to term structures of nominal and corporate bonds, and volatility and find similar downward-sloping term structures.
The authors find that short-term dividend strips have performed well relative to the predictions of several leading asset pricing models, which predict a risk premium for short-term strips close to zero. Even relative to the index, dividend strips have performed well. They find that the term structure of the equity risk premium is downward-sloping for at least part of the maturity space.
1. Downward sloping term structure of equity risk premium: the average total return on short-term dividend strips is statistically significantly higher than the total return of the index.
a. Outperformance: For all four regions studied (Europe, Japan, UK, US), dividend strips have outperformed their corresponding index suggesting that short-term dividend risks earn a large positive risk premium (Fig. 1). This also holds for dividend spot contracts although to a lesser extent.
b. Excess volatility but low market co-movement (low beta): Dividend future prices move more than their corresponding dividend realizations. Also, on average, the dividend futures price is substantially lower than the corresponding realization illustrating again the large risk premium of short-term dividend risk. For short-maturity dividend futures contracts, the CAPM betas are low (around 0.5) and gradually rise to a beta of one for longer maturities.
2. Declining Sharpe ratios in other asset classes: Sharpe ratios also significantly decline with maturity in nominal bond, corporate bond, and option markets.
3. Models fail to explain these findings: The authors test various prevailing macro-finance models in order to explain the term structure of dividend strips. Yet, none of the addressed models is able to explain the data fully. Further models with potential explanations are shortly discussed in the paper.
Observing assets that pay off a single dividend of a stock index at a future point in time could help to promote rational pricing. In recent years, it has been widely tried to measure the term structure of equity. The authors show that dividend strips have higher average returns and Sharpe ratios than the aggregate stock market leading to a downward-sloping term structure. This gives important insight into new theories trying to explain these facts and show that many of the recently documented puzzles in the asset pricing literature related to the equity premium, variance risk premium, excess volatility, return predictability, and credit spreads are predominantly short-term rather than long-term puzzles.