Asset Pricing Tests with Long Run Risks in Consumption Growth

76 Pages Posted: 16 Mar 2008 Last revised: 27 Jul 2011

See all articles by George M. Constantinides

George M. Constantinides

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Anisha Ghosh

Carnegie Mellon University

Multiple version iconThere are 2 versions of this paper

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

Constantinides, George M. and Ghosh, Anisha, Asset Pricing Tests with Long Run Risks in Consumption Growth (January 2, 2011). Fama-Miller Working Paper ; Chicago Booth Working Paper 11-25. Available at SSRN: https://ssrn.com/abstract=1104737 or http://dx.doi.org/10.2139/ssrn.1104737

George M. Constantinides (Contact Author)

University of Chicago - Booth School of Business ( email )

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Anisha Ghosh

Carnegie Mellon University ( email )

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