Long-Run Risk Through Consumption Smoothing
67 Pages Posted: 27 Feb 2007 Last revised: 27 Jul 2011
Date Written: December 3, 2007
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: Suggested Citation