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Cash flow and risk premium dynamics in an equilibrium asset-pricing model with recursive preferences

Author

Listed:
  • Taeyoung Doh
  • Shu Wu

Abstract

Under linear approximations for asset prices and the assumption of independence between expected consumption growth and time-varying volatility, long-run risks models imply constant market prices of risks and often generate counterfactual results about asset return and cash ?ow predictability. We develop and estimate a nonlinear equilibrium asset pricing model with recursive preferences and a ?exible econometric speci?cation of cash ?ow processes. While in many long-run risks models time-varying volatility in?uences only risk premium but not expected cash ?ows, in our model a common set of risk factors drive both expected cash ?ow and risk premium dynamics. This feature helps the model to overcome two main criticisms against long-run risk models following Bansal and Yaron (2004): the over-predictability of cash ?ows by asset prices and the tight relation between time-varying risk premia and growth volatility. Our model extends the approach in Le and Singleton (2010) to a setting with multiple cash ?ows. We estimate the model using the long-run historical data in the U.S. and ?nd that the model with generalized market prices of risks produces cash ?ow and return predictability that are more consistent with the data.

Suggested Citation

  • Taeyoung Doh & Shu Wu, 2015. "Cash flow and risk premium dynamics in an equilibrium asset-pricing model with recursive preferences," Research Working Paper RWP 15-12, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:rwp15-12
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    File URL: https://www.kansascityfed.org/documents/4951/cash-flow-risk-premium-dynamics-rwp15-12.pdf
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    References listed on IDEAS

    as
    1. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
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    3. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
    4. Ravi Bansal & Dana Kiku & Ivan Shaliastovich & Amir Yaron, 2014. "Volatility, the Macroeconomy, and Asset Prices," Journal of Finance, American Finance Association, vol. 69(6), pages 2471-2511, December.
    5. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
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    8. Anh Le & Kenneth J. Singleton, 2010. "An Equilibrium Term Structure Model with Recursive Preferences," American Economic Review, American Economic Association, vol. 100(2), pages 557-561, May.
    9. Beeler, Jason & Campbell, John Y., 2012. "The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment," Critical Finance Review, now publishers, vol. 1(1), pages 141-182, January.
    10. Edward P. Herbst & Frank Schorfheide, 2016. "Bayesian Estimation of DSGE Models," Economics Books, Princeton University Press, edition 1, number 10612.
    11. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887, Elsevier.
    12. Bansal, Ravi & Kiku, Dana & Yaron, Amir, 2012. "An Empirical Evaluation of the Long-Run Risks Model for Asset Prices," Critical Finance Review, now publishers, vol. 1(1), pages 183-221, January.
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    More about this item

    Keywords

    Recursive preferences; Consumption risks;

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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