The Term Structure of Equity Risk Premia: Levered Noise and New Estimates

Abstract

Levered noise occurs when no-arbitrage replication hedges fundamentals but amplifies price errors. Motivated by our theory, we use widely-available end-of-day OptionMetrics data to improve accuracy of synthetic dividend strip prices and provide longer samples than prior studies. Term structure point estimates are approximately flat in simple returns (88 bp/month vs. 87 bp/month for short-term dividends vs. index), and upward-sloping in measurement-error-robust logarithmic returns (43 bp/month vs. 77 bp/month). These results from prominent index options show the importance of diagnosing noise in no-arbitrage prices. Prior conclusions of an average downward slope in the equity term structure are not robust.