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

Posted: 24 Nov 2009

See all articles by Lars A. Lochstoer

Lars A. Lochstoer

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

Date Written: December 2009

Abstract

This paper proposes a representative agent habit-formation model where preferences are defined for both luxury goods and basic goods. The model matches the equity risk premium, risk-free rate, and volatilities. From the intratemporal first-order condition, one can substitute out basic good consumption and the habit level, yielding a stochastic discount factor driven by two observable risk factors: luxury good consumption and the relative price of the two goods. I estimate these processes and find them to be heteroskedastic, implying time variation in the conditional volatility of the stochastic discount factor. These dynamics occur both at the business cycle frequency and at a lower, “generational” frequency. The findings reveal that the time variation in aggregate stock market and Treasury bond risk premiums are consistent with the predictions of the model.

Keywords: E2, G1

Suggested Citation

Lochstoer, Lars A., Expected Returns and the Business Cycle: Heterogeneous Goods and Time-Varying Risk Aversion (December 2009). The Review of Financial Studies, Vol. 22, Issue 12, pp. 5251-5294, 2009. Available at SSRN: https://ssrn.com/abstract=1509899 or http://dx.doi.org/hhp045

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

Register to save articles to
your library

Register

Paper statistics

Abstract Views
225
PlumX Metrics