Expected Returns and the Business Cycle: Heterogeneous Goods and Time-Varying Risk Aversion

53 Pages Posted: 4 Nov 2008

See all articles by Lars A. Lochstoer

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management

Date Written: August 19, 2008

Abstract

We propose a representative agent habit formation model where preferences are defined over both luxury goods and basic goods. The model matches the equity risk premium, risk free rate, and volatilities. From the intratemporal first order condition we can substitute out basic good consumption and the habit level, yielding a stochastic discount factor driven by two observable risk factors: luxury good consumption growth, and the relative price of the two goods. We estimate these processes and find them to be heteroskedastic, implying time-variation in the conditional volatility of our stochastic discount factor. These dynamics occur both at the business cycle frequency and at a lower, "generational frequency". Consistent with the model's predictions, we empirically document the existence of these two frequencies in the equity premium, where the lower frequency is quantitatively more important. We also investigate the model's implications for bond returns, and relate their predictability to the low frequency variation in the conditional volatility of the relative price growth.

Keywords: Asset Pricing, Consumption, Heterogeneous Goods, Habit Formation, Predictability,

Suggested Citation

Lochstoer, Lars A., Expected Returns and the Business Cycle: Heterogeneous Goods and Time-Varying Risk Aversion (August 19, 2008). Available at SSRN: https://ssrn.com/abstract=1292822 or http://dx.doi.org/10.2139/ssrn.1292822

Lars A. Lochstoer (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

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