Asset Pricing with Left-Skewed Long-Run Risk in Durable Consumption

Abstract:     
I document that durable consumption growth is persistent and predicted by the price-dividend ratio. This provides strong and direct evidence for the existence of a highly persistent expected component. I also document robust evidence that durable consumption growth is left skewed and exhibits time-varying volatility. Based on these empirical properties, I model durable consumption growth as containing a persistent expected component and driven by shocks with counter-cyclical volatility. I embed the durable consumption growth dynamics and random walk nondurable consumption growth in nonseparable Epstein-Zin preferences, and model dividend growth as a levered claim on the expected component of durable consumption growth. The resulting model can explain a number of asset pricing phenomena, including pro-cyclical price-dividend ratios, large and counter-cyclical equity premia and stock return volatilities, low and smooth risk-free rates, and the predictability of stock returns. The model also generates the volatility feedback effect and an upward sloping term structure of real bond yields.

Number of Pages in PDF File: 55

Keywords: Skewness, Long-Run Risk, Durable Consumption, Equity Premium Puzzle

JEL Classification: G12

working papers series