[We decompose aggregate market variance into an average correlation component and an average variance component. Only the latter commands a negative price of risk in the cross section of portfolios sorted by idiosyncratic volatility. Portfolios with high (low) idiosyncratic volatility relative to the Fama-French (1993) model have positive (negative) exposures to innovations in average stock variance and therefore lower (higher) expected returns. These two findings explain the idiosyncratic volatility puzzle of Ang et al. (2006, 2009). The factor related to innovations in average variance also reduces the pricing errors of book-to-market and momentum portfolios relative to the Fama-French (1993) model.]

Discount rates affect stock prices directly via the discount-rate channel or indirectly via the cash-flow channel because expected future cash-flow growth varies with the discount rate. The traditional Macaulay duration captures the effect from the discount-rate channel. I propose a novel duration measure, the effective equity duration, to capture the effects from both channels. I estimate it around unexpected policies in the federal funds rates. I find that the equity yield curve is hump-shaped because expected future cash-flow growth increases with the discount rate. The effective equity duration captures information other than monetary policy risk.

Time-to-build, time-to-produce, and inventory have important implications for asset prices and quantity dynamics in a general equilibrium model with recursive preferences. Time-to-build captures the delay in transforming new investments into productive capital, and time-to-produce captures the delay in transforming productive capital into output. Both delays increase risks in that time-to-build generates procyclical payouts, whereas the time-to-produce amplifies this procyclicality. Inventory smooths consumption and helps capture interest rate volatility even when the elasticity of intertemporal substitution is small. The model is consistent with a high equity premium, a high stock return volatility, and lead-lag relations between asset prices and macroeconomic quantities.

Time-preference shocks affect agents’ preferences for assets with different durations. We consider longevity risk as a source of time-preference shocks and model it in the recursive preferences setting. This implies a consumption-based three-factor model, including longevity risk, consumption growth rate, and the market portfolio, where longevity has a negative price of risk. Empirically, this model explains many well-known cross-sectional portfolios. Notably, we find that longevity risk and the momentum factor share a common business cycle component, i.e., short-run consumption risks. Prior winners (losers) provide hedging against mortality (longevity) risk and thus have higher (lower) expected returns, because winners have higher dividend growth and shorter equity durations than losers. Time-varying longevity risk captures most momentum profits over time, including the large momentum crashes observed in the data.

We decompose aggregate market variance into an average correlation component and an average variance component. Only the latter commands a negative price of risk in the cross section of portfolios sorted by idiosyncratic volatility. Portfolios with high (low) idiosyncratic volatility relative to the Fama-French (1993) model have positive (negative) exposures to innovations in average stock variance and therefore lower (higher) expected returns. These two findings explain the idiosyncratic volatility puzzle of Ang et al. (2006, 2009). The factor related to innovations in average variance also reduces the pricing errors of book-to-market and momentum portfolios relative to the Fama-French (1993) model. (JEL G12) In an influential study, Ang, Hodrick, Xing, and Zhang (2006, 2009; AHXZ hereafter) show that stocks with high idiosyncratic risk, defined as the standard deviation of the residuals from the Fama-French (1993) model, have anomalously low future returns.1 This finding is puzzling in light of theories that suggest that idiosyncratic volatility (denoted as IV) should be irrelevant or positively related to expected returns.2 If a factor is missing from the Fama-French model, the sensitivity of stocks to the missing factor times the movement in the missing factor will show up in the residuals of the model. Firms with greater sensitivities to the missing factor We thank Geert Bekaert (editor), two anonymous referees, and seminar participants at the Norwegian Business School (BI) and Texas A&M University for many valuable comments and suggestions. Chen acknowledges financial support from a Nanyang Technological University Start-up Grant. Send correspondence to Ralitsa