Asset Pricing with Unknown Consumption and Financial Risk
University of Houston - Department of Finance
March 14, 2011
Do parameter uncertainties regarding different risk factors have symmetric effects on asset prices? In a general equilibrium setting where uncertainties regarding consumption and portfolio returns are of concern to investors but all the structural parameters of consumption and dividend growth rates are unknown, we provide a numerically tractable framework to compare empirically the effects on equilibrium asset prices of learning about consumption and dividends dynamics simultaneously in real time from aggregate U.S. data during 1890-2007. More pessimistic or optimistic priors on the means of the growth rates have transient effects, but raising the prior volatilities of growth have persistent effects that increase substantially the average equity premium and the market Sharpe ratio while lowering the average risk free return. Raising the prior volatility of consumption growth alone has significantly stronger effects on market outcomes compared to unilaterally increasing the prior volatility of dividend growth, but simultaneous parameter uncertainties on the risk of financial and non-financial payoffs reinforce each other to magnify their effects. Learning reduces the volatility of the equilibrium equity premium over time but does not generate a smooth convergence to a low equity premium even after 100 years of data.
Number of Pages in PDF File: 54
Keywords: Parameter Uncertainty, Consumption and Dividend Dynamics, Equity Premium, Persistence
JEL Classification: C11, D53, D83, E21, G12
Date posted: March 15, 2011
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