Corporate cash flows are highly volatile and strongly procyclical. We examine the asset-pricing implications of the sensitivity of corporate cash flows to economic shocks within a continuous-time model in which dividends are a stochastic fraction of aggregate consumption. We provide closed-form solutions for stock values and show that the equity premium can be represented as the sum of three components which we call the consumption-risk, event-risk, and corporate-risk premia. Calibrated to historical data, the model implies a total equity premium many times larger than in the standard model. The model also generates levels of equity volatility consistent with those experienced in the stock market.

We derive the optimal investment policy of a risk-averse investor in a market where there is a textbook arbitrage opportunity, but where liabilities must be secured by collateral. We find that it is often optimal to underinvest in the arbitrage by taking a smaller position than collateral constraints allow. Even when the optimal policy is followed, the arbitrage portfolio typically experiences losses before the final convergence date. In fact, its initial performance may be indistinguishable from that of a conventional portfolio with a poor track record. These results have important implications for the role of arbitrageurs in financial markets.

We derive the optimal investment policy of a risk-averse investor in a market where there is a textbook arbitrage opportunity, but where liabilities must be secured by collateral. We find that it is often optimal to underinvest in the arbitrage by taking a smaller position than collateral constraints allow. Even when the optimal policy is followed, the arbitrage portfolio typically experiences losses before the final convergence date. In fact, its initial performance may be indistinguishable from that of a conventional portfolio with a poor track record. These results have important implications for the role of arbitrageurs in financial markets.

ABSTRACT We conduct an empirical analysis of forward prices in the PJM electricity market using a high‐frequency data set of hourly spot and day‐ahead forward prices. We find that there are significant risk premia in electricity forward prices. These premia vary systematically throughout the day and are directly related to economic risk factors, such as the volatility of unexpected changes in demand, spot prices, and total revenues. These results support the hypothesis that electricity forward prices in the Pennsylvania, New Jersey, and Maryland market are determined rationally by risk‐averse economic agents.