Revisiting Asset Pricing with Uncertainty in Future Preferences

Abstract

We demonstrate that uncertainty about future preferences is of first-order importance for understanding the history of aggregate asset prices. Our analysis shows that simply relaxing the assumption of deterministic aggregate elasticity of intertemporal substitution and relative risk aversion can resolve a large array of aggregate asset pricing puzzles. These puzzles include the high equity premium, low risk-free rate, and the predictability (and nonpredictability) relationships among price-dividend ratios, excess returns, and consumption or dividend growth. Our model also generates time variation of dividend yields, risk premia, excess return volatilities, and Sharpe ratios, as well as an upward-sloping real yield curve.

Keywords: Equity Premium Puzzle, Elasticity of Intertemporal Substitution, Epstein-Zin Preferences, Real Term Structure, Risk Aversion, Predictability, Time-Varying Preferences

JEL Classification: G12, E44, G02