IDEAS home Printed from https://ideas.repec.org/p/fip/fedgfe/2014-59.html
   My bibliography  Save this paper

Precautionary Volatility and Asset Prices

Author

Abstract

Many theories of asset prices assume time-varying uncertainty in order to generate time-varying risk premia. This paper generates time-varying uncertainty endogenously, through precautionary saving dynamics. Precautionary motives prescribe that, in bad times, next period's consumption should be very sensitive to news. This time-varying sensitivity results in time-varying consumption volatility. Production makes this channel visible, and external habit preferences amplify it. An estimated model featuring this channel quantitatively accounts for excess return and dividend predictability regressions. It also matches the first two moments of excess equity returns, the risk-free rate, and the second moments of consumption, output, and investment.

Suggested Citation

  • Andrew Y. Chen, 2014. "Precautionary Volatility and Asset Prices," Finance and Economics Discussion Series 2014-59, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2014-59
    as

    Download full text from publisher

    File URL: http://www.federalreserve.gov/pubs/feds/2014/201459/201459pap.pdf
    File Function: Full text
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Kuehn Lars-Alexander & Petrosky-Nadeau Nicolas & Zhang Lu, "undated". "An Equilibrium Asset Pricing Model with Labor Market Search," GSIA Working Papers 2010-E63, Carnegie Mellon University, Tepper School of Business.
    2. Nicholas Bloom & Max Floetotto & Nir Jaimovich & Itay Saporta†Eksten & Stephen J. Terry, 2018. "Really Uncertain Business Cycles," Econometrica, Econometric Society, vol. 86(3), pages 1031-1065, May.
    3. Restoy, Fernando & Rockinger, G Michael, 1994. "On Stock Market Returns and Returns on Investment," Journal of Finance, American Finance Association, vol. 49(2), pages 543-556, June.
    4. Vasco Carvalho & Xavier Gabaix, 2013. "The Great Diversification and Its Undoing," American Economic Review, American Economic Association, vol. 103(5), pages 1697-1727, August.
    5. Pástor, Ľuboš & Veronesi, Pietro, 2013. "Political uncertainty and risk premia," Journal of Financial Economics, Elsevier, vol. 110(3), pages 520-545.
    6. Kogan, Leonid, 2004. "Asset prices and real investment," Journal of Financial Economics, Elsevier, vol. 73(3), pages 411-431, September.
    7. Emmanuel Farhi & Xavier Gabaix, "undated". "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    8. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
    9. Bansal, Ravi & Khatchatrian, Varoujan & Yaron, Amir, 2005. "Interpretable asset markets?," European Economic Review, Elsevier, vol. 49(3), pages 531-560, April.
    10. Bekaert, Geert & Engstrom, Eric & Grenadier, Steven R., 2010. "Stock and bond returns with Moody Investors," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 867-894, December.
    11. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," The Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    12. Martin Lettau & Sydney C. Ludvigson & Jessica A. Wachter, 2008. "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?," The Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1653-1687, July.
    13. Adrien Verdelhan, 2010. "A Habit‐Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    14. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," Econometrica, Econometric Society, vol. 77(6), pages 1711-1750, November.
    15. Duffie, Darrell & Singleton, Kenneth J, 1993. "Simulated Moments Estimation of Markov Models of Asset Prices," Econometrica, Econometric Society, vol. 61(4), pages 929-952, July.
    16. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
    17. Geert Bekaert & Eric Engstrom, 2009. "Asset Return Dynamics under Bad Environment Good Environment Fundamentals," NBER Working Papers 15222, National Bureau of Economic Research, Inc.
    18. Morten O. Ravn & Harald Uhlig, 2002. "On adjusting the Hodrick-Prescott filter for the frequency of observations," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 371-375.
    19. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    20. Glosten, Lawrence R & Jagannathan, Ravi & Runkle, David E, 1993. "On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks," Journal of Finance, American Finance Association, vol. 48(5), pages 1779-1801, December.
    21. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    22. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
    23. Ravi Bansal & A. Ronald Gallant & George Tauchen, 2007. "Rational Pessimism, Rational Exuberance, and Asset Pricing Models," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 74(4), pages 1005-1033.
    24. Beeler, Jason & Campbell, John Y., 2012. "The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment," Critical Finance Review, now publishers, vol. 1(1), pages 141-182, January.
    25. Robert J. Barro, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 121(3), pages 823-866.
    26. Miklós Koren & Silvana Tenreyro, 2013. "Technological Diversification," American Economic Review, American Economic Association, vol. 103(1), pages 378-414, February.
    27. Urban Jermann & Vincenzo Quadrini, 2012. "Macroeconomic Effects of Financial Shocks," American Economic Review, American Economic Association, vol. 102(1), pages 238-271, February.
    28. Martin Lettau, 2003. "Inspecting The Mechanism: Closed-Form Solutions For Asset Prices In Real Business Cycle Models," Economic Journal, Royal Economic Society, vol. 113(489), pages 550-575, July.
    29. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," The Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
    30. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
    31. Lars Ljungqvist & Harald Uhlig, 2009. "Optimal Endowment Destruction under Campbell-Cochrane Habit Formation," NBER Working Papers 14772, National Bureau of Economic Research, Inc.
    32. Carroll, Christopher D & Kimball, Miles S, 1996. "On the Concavity of the Consumption Function," Econometrica, Econometric Society, vol. 64(4), pages 981-992, July.
    33. Posch, Olaf, 2011. "Risk premia in general equilibrium," Journal of Economic Dynamics and Control, Elsevier, vol. 35(9), pages 1557-1576, September.
    34. Pástor, Ľuboš & Veronesi, Pietro, 2013. "Political uncertainty and risk premia," Journal of Financial Economics, Elsevier, vol. 110(3), pages 520-545.
    35. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(2), pages 645-700.
    36. Christopher D. Carroll, 2001. "A Theory of the Consumption Function, with and without Liquidity Constraints," Journal of Economic Perspectives, American Economic Association, vol. 15(3), pages 23-45, Summer.
    37. Francois Gourio, 2012. "Disaster Risk and Business Cycles," American Economic Review, American Economic Association, vol. 102(6), pages 2734-2766, October.
    38. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887, Elsevier.
    39. Jermann, Urban J., 2010. "The equity premium implied by production," Journal of Financial Economics, Elsevier, vol. 98(2), pages 279-296, November.
    40. repec:fth:jonhop:390 is not listed on IDEAS
    41. Carroll Christopher Dixon, 2001. "Death to the Log-Linearized Consumption Euler Equation! (And Very Poor Health to the Second-Order Approximation)," The B.E. Journal of Macroeconomics, De Gruyter, vol. 1(1), pages 1-38, April.
    42. Kandel, Shmuel & Stambaugh, Robert F, 1990. "Expectations and Volatility of Consumption and Asset Returns," The Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 207-232.
    43. Nicholas Bloom, 2009. "The Impact of Uncertainty Shocks," Econometrica, Econometric Society, vol. 77(3), pages 623-685, May.
    44. Bansal, Ravi & Kiku, Dana & Yaron, Amir, 2012. "An Empirical Evaluation of the Long-Run Risks Model for Asset Prices," Critical Finance Review, now publishers, vol. 1(1), pages 183-221, January.
    45. John H. Cochrane, 2011. "Presidential Address: Discount Rates," Journal of Finance, American Finance Association, vol. 66(4), pages 1047-1108, August.
    46. Leonid Kogan & Dimitris Papanikolaou, 2012. "Economic Activity of Firms and Asset Prices," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 361-384, October.
    47. repec:bla:jfinan:v:59:y:2004:i:4:p:1777-1804 is not listed on IDEAS
    48. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
    49. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
    50. Urban Jermann & Vincenzo Quadrini, 2012. "Erratum: Macroeconomic Effects of Financial Shocks," American Economic Review, American Economic Association, vol. 102(2), pages 1186-1186, April.
    51. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
    52. Sbuelz, Alessandro & Trojani, Fabio, 2008. "Asset prices with locally constrained-entropy recursive multiple-priors utility," Journal of Economic Dynamics and Control, Elsevier, vol. 32(11), pages 3695-3717, November.
    53. Georg Kaltenbrunner & Lars A. Lochstoer, 2010. "Long-Run Risk through Consumption Smoothing," The Review of Financial Studies, Society for Financial Studies, vol. 23(8), pages 3190-3224, August.
    54. repec:dgr:kubcen:199554 is not listed on IDEAS
    55. Cochrane, John H, 1992. "Explaining the Variance of Price-Dividend Ratios," The Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 243-280.
    56. repec:bla:jfinan:v:59:y:2004:i:4:p:1481-1509 is not listed on IDEAS
    57. Santos, Tano & Veronesi, Pietro, 2010. "Habit formation, the cross section of stock returns and the cash-flow risk puzzle," Journal of Financial Economics, Elsevier, vol. 98(2), pages 385-413, November.
    58. Martin Lettau & Harald Uhlig, 2000. "Can Habit Formation be Reconciled with Business Cycle Facts?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(1), pages 79-99, January.
    59. Cochrane, John H, 1991. "Production-Based Asset Pricing and the Link between Stock Returns and Economic Fluctuations," Journal of Finance, American Finance Association, vol. 46(1), pages 209-237, March.
    60. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Andrew Y. Chen, 2014. "Habit, Production, and the Cross-Section of Stock Returns," Finance and Economics Discussion Series 2014-103, Board of Governors of the Federal Reserve System (U.S.).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Andrew Y. Chen, 2013. "External Habit in a Production Economy," 2013 Papers pch1244, Job Market Papers.
    2. Jerry Tsai & Jessica A. Wachter, 2015. "Disaster Risk and its Implications for Asset Pricing," NBER Working Papers 20926, National Bureau of Economic Research, Inc.
    3. Liu, Hening & Miao, Jianjun, 2015. "Growth uncertainty, generalized disappointment aversion and production-based asset pricing," Journal of Monetary Economics, Elsevier, vol. 69(C), pages 70-89.
    4. Babiak, Mykola & Kozhan, Roman, 2024. "Parameter learning in production economies," Journal of Monetary Economics, Elsevier, vol. 144(C).
    5. Cochrane, John H., 2005. "Financial Markets and the Real Economy," Foundations and Trends(R) in Finance, now publishers, vol. 1(1), pages 1-101, July.
    6. Fabrice Collard & Sujoy Mukerji & Kevin Sheppard & Jean‐Marc Tallon, 2018. "Ambiguity and the historical equity premium," Quantitative Economics, Econometric Society, vol. 9(2), pages 945-993, July.
    7. John H. Cochrane, 2017. "Macro-Finance," Review of Finance, European Finance Association, vol. 21(3), pages 945-985.
    8. Ludvigson, Sydney C., 2013. "Advances in Consumption-Based Asset Pricing: Empirical Tests," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 799-906, Elsevier.
    9. François Gourio, 2013. "Credit Risk and Disaster Risk," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 1-34, July.
    10. David Backus & Mikhail Chernov & Stanley Zin, 2014. "Sources of Entropy in Representative Agent Models," Journal of Finance, American Finance Association, vol. 69(1), pages 51-99, February.
    11. Bai, Hang & Zhang, Lu, 2022. "Searching for the equity premium," Journal of Financial Economics, Elsevier, vol. 143(2), pages 897-926.
    12. Posch, Olaf, 2011. "Risk premia in general equilibrium," Journal of Economic Dynamics and Control, Elsevier, vol. 35(9), pages 1557-1576, September.
    13. Roberto Marfè & Julien Penasse, 2016. "The Time-Varying Risk of Macroeconomic Disasters," Carlo Alberto Notebooks 463, Collegio Carlo Alberto.
    14. Kuehn Lars-Alexander & Petrosky-Nadeau Nicolas & Zhang Lu, "undated". "An Equilibrium Asset Pricing Model with Labor Market Search," GSIA Working Papers 2010-E63, Carnegie Mellon University, Tepper School of Business.
    15. Stijn Claessens & M Ayhan Kose, 2018. "Frontiers of macrofinancial linkages," BIS Papers, Bank for International Settlements, number 95.
    16. Francois Gourio, 2012. "Disaster Risk and Business Cycles," American Economic Review, American Economic Association, vol. 102(6), pages 2734-2766, October.
    17. Jessica Wachter & Mete Kilic, 2017. "Risk, Unemployment, and the Stock Market: A Rare-Event-Based Explanation of Labor Market Volatility," 2017 Meeting Papers 129, Society for Economic Dynamics.
    18. Carolin Pflueger & Emil Siriwardane & Adi Sunderam, 2019. "Financial Market Risk Perceptions and the Macroeconomy," NBER Working Papers 26290, National Bureau of Economic Research, Inc.
    19. Kung, Howard, 2015. "Macroeconomic linkages between monetary policy and the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 115(1), pages 42-57.
    20. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887, Elsevier.

    More about this item

    Keywords

    Time-varying risk premia; equity premium puzzle; time-varying volatility; habit; precautionary savings;
    All these keywords.

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedgfe:2014-59. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Ryan Wolfslayer ; Keisha Fournillier (email available below). General contact details of provider: https://edirc.repec.org/data/frbgvus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.