Asset Return Dynamics Under Bad Environment-Good Environment Fundamentals

Abstract

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: Equity Premium, Variance Premium, Countercyclical Risk Aversion, Economic Uncertainty, Dividend Yield, Return Predictability

JEL Classification: G12, G15, E44