The term structure of the expected market risk premium, and the cross-section of stock returns

In this paper, we test whether innovations in the term structure of the expected market risk premium are a priced factor in the cross-section of equity returns or, on the contrary, equity market expectations across alternative horizons simply capture aggregate volatility risk. Using supervised principal component analysis to control for weak factors, we first select the test assets, and also the risk factors and non-tradeable state variables that individually show a significant risk premium. Then, we perform a cross-sectional analysis using shocks from a first-order vector autoregressive process that employs the market and previously selected test assets and state variables. Shocks to the three first principal components of the term structure of the expected market risk premium seem to contain significant pricing information in the cross-section beyond that of the VIX.