A Long-run Risks Model with Long- and Short-Run Volatilities: Explaining Predictability and Volatility Risk Premium

Abstract:     
In this paper, we extend the long-run risks model of Bansal and Yaron (BY, 2004) to allow both a long- and a short-run volatility component in consumption growth, long-run risks, and dividend growth. Our two volatility model better captures macroeconomic volatility than a single volatility model, and can reconcile simultaneously the large negative market variance risk premium, differing predictability in excess returns, consumption, dividends, and stock market volatility, all of which are difficult to explain previously by the BY model.

Keywords: Long-run Risk, Equity Risk Premium, Predictability, Variance Risk Premium

JEL Classifications: G12, G13, E43

Working Paper Series