Asset Return Dynamics Under Bad Environment-Good Environment Fundamentals
52 Pages Posted: 27 Dec 2010
Date Written: December 2010
We introduce a "bad environment-good environment" technology for consumption growth in a consumption-based asset pricing model. Using the preference structure from Campbell and Cochrane (1999), the model generates realistic time-varying volatility, skewness and kurtosis in fundamentals while still permitting closed-form solutions for asset prices. The model not only fits standard salient asset prices features including means and volatilities for equity returns and risk free rates, but also generates a realistic variance premium and option prices.
Keywords: countercyclical risk aversion, dividend yield, economic uncertainty, equity premium, return predictability, variance premium
JEL Classification: E44, G12, G15
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