Implications of Return Predictability for Consumption Dynamics and Asset Pricing

53 Pages Posted: 4 Dec 2012  

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Fulvio Ortu

Bocconi University - Department of Finance

Andrea Tamoni

London School of Economics & Political Science (LSE)

Haoxi Yang

Nankai University

Date Written: June 15, 2018

Abstract

Two broad classes of consumption dynamics - long-run risks and rare disasters - have proven successful in explaining the equity premium puzzle when used in conjunction with recursive preference. We show that bounds a-la Gallant, Hansen and Tauchen (1990) that restrict the volatility of the Stochastic Discount Factor by conditioning on a set of return predictors constitute a useful tool to discriminate between these alternative dynamics. In particular we document that models that rely on rare disasters meet comfortably the bounds independently of the forecasting horizon and the asset classes used to construct the bounds. However, the specific nature of disasters is a relevant characteristic at the 1-year horizon: disasters that unfold over multiple years are more successful in meeting the predictors-based bounds than one-period disasters. Instead, over a longer, 5-year horizon, the sole presence of disasters - even if one-period and permanent - is sufficient for the model to satisfy the bounds. Finally, the bounds point to multiple volatility components in consumption as a promising dimension for long-run risks models.

Keywords: stochastic discount factor, predictors-based bounds, long run

JEL Classification: G12, E21, E32, E44

Suggested Citation

Favero, Carlo A. and Ortu, Fulvio and Tamoni, Andrea and Yang, Haoxi, Implications of Return Predictability for Consumption Dynamics and Asset Pricing (June 15, 2018). Available at SSRN: https://ssrn.com/abstract=2184254 or http://dx.doi.org/10.2139/ssrn.2184254

Carlo A. Favero

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Fulvio Ortu

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Andrea Tamoni (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
02079557303 (Phone)

Haoxi Yang

Nankai University ( email )

Tongyan Road 38
Tianjin, Tianjin 300350
China

Register to save articles to
your library

Register

Paper statistics

Downloads
331
Abstract Views
1,905
PlumX