Long-run risk through consumption smoothing

Finance

IFA Working Paper

2006

Whenever agents have access to a production technology they will engineer optimal consumption paths. This is usually perceived as making the task of explaining asset prices much harder. We show that this is not the case in a standard production economy model where consumers have Epstein-Zin preferences and dislike negative shocks to future economic growth prospects. Endogenous consumption smoothing increases the price of risk in this economy as it induces highly persistent time-variation in expected aggregate consumption growth (long-run risk), even though technology follows a random walk. The asset pricing properties of the production economy model with i.i.d. shocks to technology are therefore actually better than the asset pricing properties of the exchange economy model counterpart with i.i.d. shocks to consumption. The model identifies an observable proxy for otherwise hard to measure expected consumption growth. Using this proxy, we test and find support for key predictions of our model in the time-series of consumption growth and the cross-section of stock returns.

FIN 454

IFA Working Paper

No