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Cash flow and risk premium dynamics in an equilibrium asset-pricing model with recursive preferences

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Listed:
  • Taeyoung Doh
  • Shu Wu

Abstract

Under linear approximations for asset prices and the assumption of independence between expected consumption growth and time-varying volatility, long-run risks models imply constant market prices of risks and often generate counterfactual results about asset return and cash ?ow predictability. We develop and estimate a nonlinear equilibrium asset pricing model with recursive preferences and a ?exible econometric speci?cation of cash ?ow processes. While in many long-run risks models time-varying volatility in?uences only risk premium but not expected cash ?ows, in our model a common set of risk factors drive both expected cash ?ow and risk premium dynamics. This feature helps the model to overcome two main criticisms against long-run risk models following Bansal and Yaron (2004): the over-predictability of cash ?ows by asset prices and the tight relation between time-varying risk premia and growth volatility. Our model extends the approach in Le and Singleton (2010) to a setting with multiple cash ?ows. We estimate the model using the long-run historical data in the U.S. and ?nd that the model with generalized market prices of risks produces cash ?ow and return predictability that are more consistent with the data.

Suggested Citation

  • Taeyoung Doh & Shu Wu, 2015. "Cash flow and risk premium dynamics in an equilibrium asset-pricing model with recursive preferences," Research Working Paper RWP 15-12, Federal Reserve Bank of Kansas City.
  • Handle: RePEc:fip:fedkrw:rwp15-12
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    References listed on IDEAS

    as
    1. Frank Schorfheide & Dongho Song & Amir Yaron, 2018. "Identifying Long‐Run Risks: A Bayesian Mixed‐Frequency Approach," Econometrica, Econometric Society, vol. 86(2), pages 617-654, March.
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    3. 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..
    4. Fernando Restoy & Philippe Weil, 2011. "Approximate Equilibrium Asset Prices," Review of Finance, European Finance Association, vol. 15(1), pages 1-28.
    5. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, August.
    6. Edward P. Herbst & Frank Schorfheide, 2016. "Bayesian Estimation of DSGE Models," Economics Books, Princeton University Press, edition 1, number 10612, April.
    7. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
    8. repec:spo:wpmain:info:hdl:2441/5l6uh8ogmqildh09h4838ip3n is not listed on IDEAS
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    More about this item

    Keywords

    Recursive preferences; Consumption risks;

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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