Asset Prices with Non-Permanent Shocks to Consumption
44 Pages Posted: 15 Jun 2014 Last revised: 5 Nov 2020
Date Written: August 19, 2016
Most standard asset-pricing models assume that all shocks to consumption are permanent. We relax this assumption and allow also for non-permanent shocks. In our specification, the long-run mean of consumption growth is constant; consumption levels are subject to short-run deviations from their long-run trend. The implications of our model are dramatically different from those obtained in the prior literature. A canonical and parsimonious asset pricing model with CRRA preferences and non-permanent shocks can reproduce the equity premium, high return volatility and return predictability with a coefficient of relative risk aversion below ten. This finding suggests that non-permanent shocks can play an important role in explaining asset pricing puzzles.
Keywords: Asset prices, equity premium, unit root, non-permanent shocks.
JEL Classification: G11, G12.
Suggested Citation: Suggested Citation