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Expected Returns and the Business Cycle: Heterogeneous Goods and Time-Varying Risk Aversion

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  • Lars A. Lochstoer

Abstract

This paper proposes a representative agent habit-formation model where preferences are defined for both luxury goods and basic goods. The model matches the equity risk premium, risk-free rate, and volatilities. From the intratemporal first-order condition, one can substitute out basic good consumption and the habit level, yielding a stochastic discount factor driven by two observable risk factors: luxury good consumption and the relative price of the two goods. I estimate these processes and find them to be heteroskedastic, implying time variation in the conditional volatility of the stochastic discount factor. These dynamics occur both at the business cycle frequency and at a lower, "generational" frequency. The findings reveal that the time variation in aggregate stock market and Treasury bond risk premiums are consistent with the predictions of the model. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Suggested Citation

  • Lars A. Lochstoer, 2009. "Expected Returns and the Business Cycle: Heterogeneous Goods and Time-Varying Risk Aversion," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5251-5294, December.
  • Handle: RePEc:oup:rfinst:v:22:y:2009:i:12:p:5251-5294
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    File URL: http://hdl.handle.net/10.1093/rfs/hhp045
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    Cited by:

    1. Ehling, Paul & Heyerdahl-Larsen, Christian, 2015. "Complete and incomplete financial markets in multi-good economies," Journal of Economic Theory, Elsevier, vol. 160(C), pages 438-462.
    2. Jessica A. Wachter & Motohiro Yogo, 2010. "Why Do Household Portfolio Shares Rise in Wealth?," Review of Financial Studies, Society for Financial Studies, vol. 23(11), pages 3929-3965, November.
    3. Yuk Ying Chang & Martin Young, 2016. "Brand Firm Performance and Tough Economic Times," International Review of Finance, International Review of Finance Ltd., vol. 16(3), pages 357-391, September.

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