Expectations and Volatility of Consumption and Asset Returns

The authors find that conditional means and variances of consumption growth vary through time, and this variation appears to be associated with the business cycle. A pricing model with fluctuating means and variances of consumption growth provides implications about conditional moments of returns for both short and long investment horizons, and these implications are explored empirically. The U-shaped pattern of first-order autocorrelations of returns, as well as business cycle patterns in the price of risk, appears to be consistent with the model, but the authors' exploration suggests that other implications about conditional return moments are at odds with the data. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.