Term structure of equity risk premia in rough terrain: 150 years of the French stock market

Abstract

We implement a state-space modeling to capture jointly the one-year and infinite horizons equity risk premia (ERPs) over a secular period in France. Expected stock returns are represented by mixing traditional expectation processes, expected variances are from GARCHX models and risk prices are stochastic state variables estimated using the Kalman filter method. Represented by the spread between long-and short-term ERPs, the term structure strongly varies over time exhibiting a dominant downward sloping. Both expected variances and risk prices are highly at play in determining the ERPs term structure, the effects of restraints on borrowing and of international stock market contagion completing the explanation. Overall, our modeling provides rather similar results using US data. We finally show that the French ERPs term structure varies with the economic cycle, the cost of capital and the liquidity preference.