Preference Shocks and Contemporaneous Cash Flow Risk

Abstract

What makes some assets `safer' than other? Assets with a low covariance between cash flow and aggregate consumption shocks (i.e. cash flow risk) serve as natural hedges against negative shocks to the economy, which makes them relatively `safer' in bad times. I propose an asset-pricing model with preference shocks and contemporaneous cash flow risk that can explain key asset-pricing patterns related to business cycle. In the model, contemporaneous cash flow risk of equities drives the cross section of risk premia in bad times, i.e. during periods with a high recession probability, relatively more than in good times due to the `preference shock effect'. This model makes new predictions about the conditional relevance of cash flow risk for asset prices, the slope of equity term structure and consumption shock elasticities that are confirmed in data. Unlike in existing models with external habits or long-run risks, I show that with preference shocks correlated with business-cycle shocks, reasonable quantities of contemporaneous cash flow risk have a significant effect on conditional risk premia of assets and return volatility.

Keywords: contemporaneous cash flow risk, safe asset characteristics, hedging consumption shocks, preference shocks, recession indicator

JEL Classification: G12