Macroeconomic Volatilities and Long-Run Risks of Asset Prices

Abstract

In this paper, motivated by existing and growing evidence on multiple macroeconomic volatilities, 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. With this extension, the new model not only is consistent with the volatility literature that the stock market is driven by two, rather than one, volatility factors, but also provides significant improvements in fitting various patterns, such as the size of market risk premium, level of interest rate, degree of dividend yield predictability, and the term structure of variance risk premiums, of both the equity and option data.

Keywords: Long-run Risk, Equity Risk Premium, Predictability, Variance Risk Premium

JEL Classification: G12, G13, E43