Asset Pricing with Uncertainty About the Long Run

When investors have preferences for early resolution of uncertainty, higher uncertainty about future growth rates raises agents’ marginal utility, which generates a premium for bearing uncertainty risk. If expected growth rates have persistent long-run dynamics, small local uncertainty about the growth rate can translate into large uncertainty about future cash flows, which amplify the uncertainty premium. We study the effects of learning on the dynamics of asset prices in an endowment economy, where agents learn about consumption growth through a nonlinear filter. The uncertainty premium is large, varies substantially over time, and tends to rise following negative consumption shocks. Moreover, a decrease in consumption volatility can sometimes sharply increase the Sharpe Ratio and risk premium.