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Asset Pricing Tests with Long Run Risks in Consumption Growth

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  • George M. Constantinides
  • Anisha Ghosh

Abstract

A novel methodology in testing the long-run risks model of Bansal and Yaron (2004) is presented based on the observation that, under the null, the potentially latent state variables, "long-run risk" and the conditional variance of its innovation, are known a¢ ne functions of the observable market-wide price-dividend ratio and risk free rate. In linear forecasting regressions of consumption growth and returns by the price-dividend ratio and risk free rate, the model implies much higher forecastability than what is observed in the data over 1931 -2009. The co-integrated variant of the model by Bansal, Gallant, and Tauchen (2007), also implies much higher forecastability of returns than what is observed in the data. Finally, we reject the models' implications in jointly pricing the cross-section of returns and fitting the unconditional time series moments of consumption and dividend growth. The results suggest that either some important state variable is missing or that the models should be generalized in a way that the lagged price-dividend ratio and risk free enter the regressions in a non-linear fashion.

Suggested Citation

  • George M. Constantinides & Anisha Ghosh, 2008. "Asset Pricing Tests with Long Run Risks in Consumption Growth," NBER Working Papers 14543, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14543
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    Cited by:

    1. Roméo Tédongap, 2015. "Consumption Volatility and the Cross-Section of Stock Returns," Review of Finance, European Finance Association, vol. 19(1), pages 367-405.
    2. repec:eee:dyncon:v:86:y:2018:i:c:p:95-122 is not listed on IDEAS
    3. Branger, Nicole & Rodrigues, Paulo & Schlag, Christian, 2017. "Level and slope of volatility smiles in Long-Run Risk Models," SAFE Working Paper Series 186, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    4. Ghosh, Anisha & Linton, Oliver, 2007. "Consistent estimation of the risk-return tradeoff in the presence of measurement error," LSE Research Online Documents on Economics 24506, London School of Economics and Political Science, LSE Library.
    5. Roberto Marfè, 2016. "Corporate Fraction and the Equilibrium Term Structure of Equity Risk," Review of Finance, European Finance Association, vol. 20(2), pages 855-905.
    6. Ravi Jagannathan & Srikant Marakani, 2011. "Price Dividend Ratio Factors : Proxies for Long Run Risk," NBER Working Papers 17484, National Bureau of Economic Research, Inc.
    7. Bakshi, Gurdip & Chabi-Yo, Fousseni, 2011. "Variance Bounds on the Permanent and Transitory Components of Stochastic Discount Factors," Working Paper Series 2011-11, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    8. Roberto Marfè, 2015. "Income Insurance and the Equilibrium Term-Structure of Equity," Carlo Alberto Notebooks 407, Collegio Carlo Alberto.
    9. Na Guo & Peter N. Smith, 2012. "Durable Consumption, Long-Run Risk and The Equity Premium," Discussion Papers 12/37, Department of Economics, University of York.
    10. repec:ucp:jpolec:doi:10.1086/694621 is not listed on IDEAS
    11. Goswami, Gautam & Tan, Sinan, 2012. "Pricing the US residential asset through the rent flow: A cross-sectional study," Journal of Banking & Finance, Elsevier, vol. 36(10), pages 2742-2756.

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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