We derive novel estimates of the equity and variance risk premia that account for intertemporal hedging motives and embed information on the market’s term structure of risk. We show that standard asset pricing models impose restrictions on how intertemporal hedging affects the equity risk premium that are inconsistent with evidence on investors' prudence and higher order risk pricing. Our more flexible framework delivers estimates that are in line with this evidence. Estimates derived from option prices indicate that intertemporal hedging accounts for up to 80% of the equity and variance risk premia, and improve the out-of-sample R2 of market return prediction.

We propose systematic variance risk as the primary factor for pricing the cross-section of equity option returns. Using a parsimonious factor model with time-varying risk premiums, we find pervasive negative variance risk premiums in index, stock, and ETF options, consistent with asset pricing theory. The magnitudes of the risk premiums are plausible and similar across markets and the cross-section of options. This highlights the central and unifying role of systematic variance risk in option markets. We emphasize aspects of model specification and empirical implementation which play a critical role in establishing this stylized fact and explain differences with existing studies.

Combining yield dynamics with an SDF pricing bonds and equities, we estimate term structures of risk premia for real bonds, nominal bonds, and equities from 1972 to 2022. We use these term structures to decompose equity risk premia into term, inflation, and cash flow components, with cash flow risk premia denoting expected returns of dividend strips over nominal bond strips. Term and inflation risk premia rise with maturity, while cash flow risk premia are hump-shaped. Importantly, long-maturity equity premia variation is driven by term and inflation risk premia, underscoring the role of bond risk premia in the excess volatility puzzle.