Asset Pricing Tests with Long Run Risks in Consumption Growth

55 Pages Posted: 11 Dec 2008 Last revised: 28 Sep 2010

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

London School of Economics & Political Science (LSE)

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Date Written: December 2008

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 a¢ ne 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.

Suggested Citation

Constantinides, George M. and Ghosh, Anisha, Asset Pricing Tests with Long Run Risks in Consumption Growth (December 2008). NBER Working Paper No. w14543, Available at SSRN: https://ssrn.com/abstract=1312634

George M. Constantinides (Contact Author)

University of Chicago - Booth School of Business ( email )

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Anisha Ghosh

London School of Economics & Political Science (LSE) ( email )

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United Kingdom

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