In Full-Information Estimates, Long-Run Risks Explain at Most a Quarter of P/D Variance, and Habit Explains even Less
64 Pages Posted: 1 Feb 2016 Last revised: 15 Nov 2019
Date Written: November 4, 2019
Many consumption-based models succeed in matching long lists of asset price moments. We propose an alternative, full-information Bayesian evaluation that decomposes the price-dividend ratio (p/d) into contributions from long-run risks, habit, and a residual. We find that long-run risks account for less than 25% of the variance of p/d and that habit's contribution is negligible. This result is robust to the prior, including priors that assume long-run risks in consumption and highly persistent habit. However, the residual mostly tracks decades-long movements in p/d. At business cycle frequency, long-run risks explain about 70% of the movements of p/d while habit's contribution stays negligible.
Keywords: Long run risks, Rare Disasters, Habit, Bayesian Estimation, Particle Filter, Time-Varying Beliefs, Time-Varying Preferences, Excess Volatility
JEL Classification: G10, G12, E21, E30, E44, C11, C15
Suggested Citation: Suggested Citation