Risks For the Long Run: A Potential Resolution of Asset Pricing Puzzles
by Ravi Bansal of Duke University, and
Abstract: We model consumption and dividend growth rates as containing (i) a small long-run predictable component and (ii) 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 risk-free rate, and the volatility of the market return, risk-free rate, and the price-dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time-varying.
Published in: Journal of Finance, Vol. 59, No. 4, August 2004, pp. 1481-1509.
Awards: Winner of the 2004 Smith-Breeden Paper Award given by the American Finance Association and the Journal of Finance