The Long-run Risks Model: What Differences Can an Extra Volatility Factor Make?
Washington University in St. Louis - Olin School of Business
Tsinghua University - School of Economics & Management
November 3, 2013
In this paper, we extend the long-run risks model of Bansal and Yaron (2004) by allowing both a long- and a short-run volatility components in the evolution of economic fundamentals. While the Bansal and Yaron model has received increasing attention recently, it has major difficulties in explaining a large negative market variance risk premium, the predictability of consumption growth by price-dividend ratio, the predictability of market volatility by price-dividend ratio, and the importance of discount rate risk relative to cash flow news. By adding one more volatility factor, our extension not only makes the new model consistent with the volatility literature that the stock market is driven by two, rather than one, volatility factors, but also resolves all the aforementioned challenging issues facing the original Bansal and Yaron model.
Number of Pages in PDF File: 43
Keywords: Long-run Risk, Equity Risk Premium, Predictability, Variance Risk Premium
JEL Classification: G12, G13, E43working papers series
Date posted: May 13, 2009 ; Last revised: November 7, 2013
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