Asset Pricing Tests with Long-run Risks in Consumption Growth

Abstract

The Bansal and Yaron (2004) model of long run risks (LLR) in aggregate consumption and dividend growth and its extension that captures potential cointegration of the consumption and dividend levels, are tested on a cross-section of asset classes and rejected using annual data over the period 1930-2006 and using both annual and quarterly data over the post-war period. The reversal of earlier empirical conclusions is partly due to the increase in the power of the tests resulting from two observations under the null. First, the latent state variables and, therefore, the pricing kernel are known a¢ ne functions of observables such as the interest rate and the market-wide price-dividend ratio. Second, the parameters of the time-series processes of consumption and dividend growth, the LLR variable, and its conditional variance impose constraints on the parameters of the pricing kernel. The value of the persistence parameter of the LRR variable that best …ts the data implies that its half-life is shorter than that of the business cycle.

Loss aversion, habit formation and the term structures of equity and interest rates

“…(2011) and cover the 1962-2008 period. Statistics of the price-dividend ratio are from Constantinides and Ghosh (2011). Consumption and preference parameters from Table B1.…”

Counter-cyclical risk aversion

“…Bansal and Yaron (2004) and Constantinides and Ghosh (2011) use affine functions of state variables for z j and z m,j , and solve for the coefficients using distributional assumptions on the disturbance terms. In this work, we take a more general approach by introducing Eqs.…”

Hidden persistent disasters and asset prices

“…Given the fact that the average size of consumption disasters observed in the international data is much larger than that in the U.S. data, potential declines in dividends during disasters would be much more severe than those observed in the U.S. data. 8 For criticisms of the long-run risks model, see, e.g., Marakani (2009), Constantinides and Ghosh (2011), and Beeler and Campbell (2012).…”