Long-Run Risk Through Consumption Smoothing

67 Pages Posted: 27 Feb 2007 Last revised: 27 Jul 2011

See all articles by Georg Kaltenbrunner

Georg Kaltenbrunner

London Business School

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management

Date Written: December 3, 2007

Abstract

We examine how long-run consumption risk arises endogenously in a standard production economy model where the representative agent has Epstein-Zin preferences. Even when technology growth is i.i.d., optimal consumption smoothing induces highly persistent time-variation in expected consumption growth (long-run risk). This increases the price of risk when investors prefer early resolution of uncertainty, and the model can then account for the low volatility of consumption growth and the high price of risk with a low coefficient of relative risk aversion. The asset price implications of endogenous long-run risk depends crucially on the persistence of technology shocks and investors preference for the timing of resolution of uncertainty. We use the time-series of consumption growth and the cross-section of stock returns to evaluate different parameterizations of the model.

Keywords: Asset Pricing, Long-Run Risk, Asset Prices and the Macroeconomy

JEL Classification: E21, E23, E30, G12

Suggested Citation

Kaltenbrunner, Georg and Lochstoer, Lars A., Long-Run Risk Through Consumption Smoothing (December 3, 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=965702 or http://dx.doi.org/10.2139/ssrn.965702

Georg Kaltenbrunner

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Lars A. Lochstoer (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

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