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Predictability in Consumption Growth and Equity Returns: A Bayesian Investigation

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  • Alex Paseka
  • George Theocharides

Abstract

We use a Bayesian method to estimate a consumption‐based asset pricing model featuring long‐run risks. Although the model is generally consistent with consumption and dividend growth moments in annual data, the conditional mean of consumption growth (a latent process) is not persistent enough to satisfy the restriction that the price‐dividend ratio be an affine function of the latent process. The model also requires relatively high intertemporal elasticity of substitution to match the low volatility of the risk‐free return. These two restrictions lead to the equity volatility puzzle. The model accounts for only 50% of the total variation in asset returns.

Suggested Citation

  • Alex Paseka & George Theocharides, 2010. "Predictability in Consumption Growth and Equity Returns: A Bayesian Investigation," The Financial Review, Eastern Finance Association, vol. 45(1), pages 167-203, February.
    • Handle: RePEc:bla:finrev:v:45:y:2010:i:1:p:167-203
    DOI: 10.1111/j.1540-6288.2009.00242.x
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    Cited by:

    1. Meissner, Thomas & Pfeiffer, Philipp, 2022. "Measuring preferences over the temporal resolution of consumption uncertainty," Journal of Economic Theory, Elsevier, vol. 200(C).
    2. Jun Ma, 2013. "Long‐Run Risk and Its Implications for the Equity Premium Puzzle: New Evidence from a Multivariate Framework," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(1), pages 121-145, February.
    3. Julian Thimme, 2017. "Intertemporal Substitution In Consumption: A Literature Review," Journal of Economic Surveys, Wiley Blackwell, vol. 31(1), pages 226-257, February.

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