Articlegreen2010

Long Run Risks, the Macroeconomy, and Asset Prices

134 citations0/0 files storedAmerican Economic Review

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Financial Markets and Investment Strategies Stochastic processes and financial applications Economic theories and models

Abstract

Long-Run Risk (LRR) model which emphasizes the role of long-run risks, that is, low-frequency movements in consumption growth rates and volatility, in accounting for a wide-range of asset pricing puzzles. In this article we present a generalized LRR model, which allows us to study the role of cyclical fluctuations and macroeconomic-crisis on asset prices and expected returns. The Bansal and Yaron (2004) LRR model contains (i) a persistent expected consumption growth component, (ii) long-run variation in consumption volatility, and (iii) preference for early resolution of uncertainty. To evaluate the role of cyclical risks, we incorporate a cyclical component in consumption growth — this component is stationary in levels. To study financial market crisis, we also entertain jumps in consumption growth and consumptionvolatility. We find that the magnitude of risk compensation for cyclical risks in consumption critically depends on the magnitude of the inter-temporal elasticity of substitution (IES). When the IES is larger than one, cyclical risks carry a very small risk-premium and the compensation for long-run risks is large. When IES is close to zero, the risk compensation for cyclical risks is large, however, in this case the risk-free rate is implausibly high (in excess of 10 percent). Given this, it seems unlikely that the compensation for cyclical risk is of economically significant magnitude. This implication is also consistent with Robert E. Jr. Lucas (1987), who argues that economic costs of transient shocks are small and those for trend shocks are large. Moreover, Ravi Bansal, Robert F. Dittmar and Dana Kiku (2009) provide evidence from equity markets that the compensation for long-run risks is large and that for cyclical risk is quite small.

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References

1989Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework 2000Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles 1987Models of business cycles 2008Consumption Strikes Back? Measuring Long‐Run Risk 2005Consumption, Dividends, and the Cross Section of Equity Returns 2010Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure 2012A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets 2013Crises and Recoveries in an Empirical Model of Consumption Disasters

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2014Optimal climate change mitigation under long-term growth uncertainty: Stochastic integrated assessment and analytic findings 2015Dividend Dynamics and the Term Structure of Dividend Strips 2018Higher Order Effects in Asset Pricing Models with Long‐Run Risks 2016Risks for the long run: Estimation with time aggregation 2021Pricing climate-related risks in the bond market

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