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Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles
Author(s) -
Bansal Ravi,
Yaron Amir
Publication year - 2004
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2004.00670.x
Subject(s) - equity premium puzzle , economics , volatility (finance) , dividend , capital asset pricing model , financial economics , equity (law) , econometrics , risk premium , implied volatility , risk free interest rate , financial market , volatility smile , monetary economics , finance , political science , law
We model consumption and dividend growth rates as containing (1) a small long‐run predictable component, and (2) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin's (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long‐run growth prospects raise equity prices. The model can justify the equity premium, the risk‐free rate, and the volatility of the market return, risk‐free rate, and the price–dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time‐varying.