Long Run and the Temporal Aggregation of Risks

63 Pages Posted: 18 Mar 2010 Last revised: 23 Nov 2010

See all articles by Fulvio Ortu

Fulvio Ortu

Bocconi University - Department of Finance

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Claudio Tebaldi

Bocconi University - CAREFIN - Centre for Applied Research in Finance; Bocconi University - Department of Finance; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research

Date Written: March 15, 2010

Abstract

The long-run risk model introduced by R.Bansal and A.Yaron (2004) assumes the existence of a small predictable component in consumption growth and an elasticity of intertemporal substitution of the representative agent larger than one for the substitution effect to dominate the income one. Previous tests fail to detect predictability in mean consumption growth fluctuations and the estimated value for the elasticity of intertemporal substitution is smaller than one. We argue that these apparent inconsistencies are due to a severe error-in-variables problem generated by the heterogeneity in the persistence levels of shocks to consumption growth. In this paper the original long run risk model is extended introducing a novel persistence based decomposition which can be considered as a refined permanent-transitory decomposition where the transitory shock is further split into orthogonal components. This new decomposition provides an effective method to represent a time series as a linear combination of innovations classified by their level of persistence and their time of arrival. Correspondingly the relations between equity return variations, cash flow risk and persistent fluctuations in the consumption mean are disaggregated across different levels of persistence and the complete term structure of risk return tradeoffs is computed. Quite remarkably, the empirical tests performed within this extended setup find evidence of consumption growth predictability, produce sizeable estimated for the equity premia and explain the value premium as an effect of the differential exposure of cash flows to consumption risk.

Keywords: Persistence heterogeneity, Temporal aggregation, Permanent-transitory decomposition, Term-structure of risks, Long-run risks

JEL Classification: C10, E44, G12

Suggested Citation

Ortu, Fulvio and Tamoni, Andrea and Tebaldi, Claudio, Long Run and the Temporal Aggregation of Risks (March 15, 2010). Available at SSRN: https://ssrn.com/abstract=1571434 or http://dx.doi.org/10.2139/ssrn.1571434

Fulvio Ortu

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Andrea Tamoni (Contact Author)

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

1 Washington Park
Newark, NJ 07102
United States

Claudio Tebaldi

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Roentgen 1
Milan, 20136
Italy

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

Register to save articles to
your library

Register

Paper statistics

Downloads
120
Abstract Views
894
rank
234,958
PlumX Metrics