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

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  • Ravi Bansal
  • Amir Yaron

Abstract

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.

Suggested Citation

  • Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:8059
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    Citations

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    Cited by:

    1. Kim, Kun Ho, 2014. "Counter-cyclical risk aversion," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 384-401.
    2. Evan W. Anderson & Eric Ghysels & Jennifer L. Juergens, 2005. "Do Heterogeneous Beliefs Matter for Asset Pricing?," Review of Financial Studies, Society for Financial Studies, vol. 18(3), pages 875-924.
    3. Jun Ma & Charles R. Nelson, 2008. "Valid Inference for a Class of Models Where Standard Inference Performs Poorly: Including Nonlinear Regression, ARMA, GARCH, and Unobserved Components," Working Papers UWEC-2008-06-R, University of Washington, Department of Economics, revised Sep 2008.
    4. Gallant, A. Ronald & Tauchen, George, 2002. "Simulated Score Methods and Indirect Inference for Continuous-time Models," Working Papers 02-09, Duke University, Department of Economics.
    5. Bansal, Ravi & Khatchatrian, Varoujan & Yaron, Amir, 2005. "Interpretable asset markets?," European Economic Review, Elsevier, vol. 49(3), pages 531-560, April.
    6. Bjørn Eraker, 2008. "Affine General Equilibrium Models," Management Science, INFORMS, vol. 54(12), pages 2068-2080, December.
    7. Bansal, Ravi & Dahlquist, Magnus, 2001. "Sovereign Risk and Return in Global Equity Markets," CEPR Discussion Papers 3034, C.E.P.R. Discussion Papers.
    8. repec:pri:wwseco:dp229 is not listed on IDEAS
    9. Pietro Veronesi, "undated". "Belief-dependent Utilities, Aversion to State-Uncertainty and Asset Prices,”," CRSP working papers 529, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    10. 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.
    11. Jakob B. Madsen & Ratbek Dzhumashev & Hui Yao, 2013. "Stock returns and economic growth," Applied Economics, Taylor & Francis Journals, vol. 45(10), pages 1257-1271, April.
    12. Bruno Feunou & Jean-Sébastien Fontaine, 2014. "Bond Risk Premia and Gaussian Term Structure Models," Staff Working Papers 14-13, Bank of Canada.
    13. Francois Gourio, 2012. "Disaster Risk and Business Cycles," American Economic Review, American Economic Association, vol. 102(6), pages 2734-2766, October.
    14. George M. Constantinides, 2002. "Rational Asset Prices," NBER Working Papers 8826, National Bureau of Economic Research, Inc.
    15. Hasseltoft, Henrik, 2007. "The Long-run Risk Model: Dynamics and Cyclicality of Interest Rates," SIFR Research Report Series 58, Institute for Financial Research.

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    JEL classification:

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

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