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Stochastic Volatility, Long Run Risks, and Aggregate Stock Market Fluctuations

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  • Stefan Avdjiev
  • Nathan Balke

Abstract

What are the main drivers of fluctuations in the aggregate US stock market? In this paper, we attempt to resolve the long-lasting debate surrounding this question by designing and solving a consumption-based asset pricing model which incorporates stochastic volatility, long-run risks in consumption and dividends, and Epstein-Zin preferences. Utilizing Bayesian MCMC techniques, we estimate the model by fitting it to US data on the level of the aggregate US stock market, the short-term real risk-free interest rate, real consumption growth, and real dividend growth. Our results indicate that, over short and medium horizons, fluctuations in the level of the aggregate US stock market are mainly driven by changes in expected excess returns. Conversely, low frequency movements in the aggregate stock market are primarily driven by changes in the expected long-run growth rate of real dividends.

Suggested Citation

  • Stefan Avdjiev & Nathan Balke, 2010. "Stochastic Volatility, Long Run Risks, and Aggregate Stock Market Fluctuations," BIS Working Papers 323, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:323
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    References listed on IDEAS

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    1. Ravi Bansal & Robert F. Dittmar & Christian T. Lundblad, 2005. "Consumption, Dividends, and the Cross Section of Equity Returns," Journal of Finance, American Finance Association, vol. 60(4), pages 1639-1672, August.
    2. Nathan S. Balke & Mark E. Wohar, 2006. "What Drives Stock Prices? Identifying the Determinants of Stock Price Movements," Southern Economic Journal, Southern Economic Association, vol. 73(1), pages 55-78, July.
    3. Ravi Bansal & Robert Dittmar & Dana Kiku, 2009. "Cointegration and Consumption Risks in Asset Returns," Review of Financial Studies, Society for Financial Studies, vol. 22(3), pages 1343-1375, March.
    4. Nathan S. Balke & Mark E. Wohar, 2002. "Low-Frequency Movements in Stock Prices: A State-Space Decomposition," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 649-667, November.
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    Cited by:

    1. Stefan Avdjiev, 2016. "News Driven Business Cycles and Data on Asset Prices in Estimated DSGE Models," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 20, pages 181-197, April.

    More about this item

    Keywords

    asset pricing; stochastic volatility; long-run risks; Bayesian MCMC Methods;

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