Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Ravi Bansal, Amir Yaron
2004 Journal of Finance  
We model consumption and dividend growth rates as containing (1) a small longrun predictable component, and (2) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin's (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long-run growth prospects raise equity prices. The model can justify the equity premium, the
more » ... ee rate, and the volatility of the market return, risk-free rate, and the pricedividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time-varying. SEVERAL KEY ASPECTS OF ASSET MARKET DATA pose a serious challenge to economic models.1 It is difficult to justify the 6% equity premium and the low risk-free rate (see Mehra and Prescott (1985), Weil (1989), and Hansen and Jagannathan (1991)). The literature on variance bounds highlights the difficulty in justifying the market volatility of 19% per annum (see Shiller (1981) and LeRoy and Porter (1981)). The conditional variance of the market return, as shown in Bollerslev, Engle, and Wooldridge (1988), fluctuates across time and is very persistent. Price-dividend ratios seem to predict long-horizon equity returns (see Campbell and Shiller (1988)). In addition, as documented in this paper, consumption volatility and future price-dividend ratios are significantly negatively correlated-a rise in consumption volatility lowers asset prices.
doi:10.1111/j.1540-6261.2004.00670.x fatcat:7x7bbhq3mfh7pfspedteppwvgq