Horizon effects in the pricing kernel: How investors price short-term versus long-term risks

We show that investors price short-term stock market outcomes very different from outcomes that occur further into the future. To this end, we introduce the expected forward pricing kernel, and decompose long-term pricing kernels into short-term and expected forward pricing kernels. Using index options, we find that kernels with maturities of up to twelve months are U-shaped, and show that this results from the shape of the one-month pricing kernel. Once we remove the impact of the one-month kernel, the expected forward kernels are in line with standard long-run risk models in terms of their shape, level, and time-series variation.