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Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

  • Ravi Bansal
  • Amir Yaron

We model dividend and consumption growth rates as containing a small long-run predictable component and economic uncertainty (i.e., growth rate volatility) as being time-varying. The magnitudes of the predictable variation and changing volatility in growth rates, as in the data, are quite small. These growth rate dynamics, for which we provide empirical support, in conjunction with plausible parameter configurations of the Epstein and Zin (1989) preferences can explain key observed asset markets phenomena. In particular, we show that the model can justify the observed equity premium, the low risk free rate, and the ex-post volatilities of the market return, real risk free rate, and the price-dividend ratio. As in the data, the model also implies that dividend yields predict returns and that market return volatility is stochastic. The main economic insight we capture is that news about growth rates significantly alter agent's perceptions regarding long run expected growth rates and growth rate uncertainty--in equilibrium, this leads to a large equity risk premium, low risk free interest rate, and large market volatility.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8059.

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Date of creation: Dec 2000
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Publication status: published as Bansal, Ravi and Amir Yaron. "Risks For The Long Run: A Potential Resolution Of Asset Pricing Puzzles," Journal of Finance, 2004, v59(4,Aug), 1481-1509.
Handle: RePEc:nbr:nberwo:8059
Note: AP
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