Asset Pricing Tests with Long Run Risks in Consumption Growth
76 Pages Posted: 16 Mar 2008 Last revised: 27 Jul 2011
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Asset Pricing Tests with Long Run Risks in Consumption Growth
Asset Pricing Tests with Long Run Risks in Consumption Growth
Date Written: January 2, 2011
Abstract
A novel methodology in testing the long-run risks model of Bansal and Yaron (2004) is presented based on the observation that, under the null, the potentially latent state variables, long-run risk and the conditional variance of its innovation, are known affine functions of the observable market-wide price-dividend ratio and risk free rate. In linear forecasting regressions of consumption growth and returns by the price-dividend ratio and risk free rate, the model implies much higher forecastability than what is observed in the data over 1931-2009. The co-integrated variant of the model by Bansal, Gallant, and Tauchen (2007), also implies much higher forecastability of returns than what is observed in the data. Finally, we reject the models' implications in jointly pricing the cross-section of returns and fitting the unconditional time series moments of consumption and dividend growth. The results suggest that either some important state variable is missing or that the models should be generalized in a way that the lagged price-dividend ratio and risk free enter the regressions in a non-linear fashion.
Keywords: Long Run Risks, Equity Premium, Cross-Section of Asset Returns, Cointegration, Latent State Variables
JEL Classification: G12, E44
Suggested Citation: Suggested Citation
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