Ambiguity, Long-Run Risks, and Asset Prices

Abstract

We generalize the long-run risks (LRR) model in Bansal and Yaron (2004) by incorporating the recursive smooth ambiguity aversion preferences of Klibanoff, Marinacci, and Mukerji (2005, 2009) and time-varying ambiguity. Relative to the Bansal-Yaron model, the generalized LRR model remains tractable and is more flexible due to the separation of ambiguity aversion from risk aversion and the intertemporal elasticity of substitution. The three-way separation allows the model to further account for the variance premium puzzle, besides the puzzles of the equity premium, the risk-free rate, and the return predictability. Specifically, the model matches reasonably well key asset pricing moments with risk aversion under 5. By calibration we show that the ambiguity aversion channel accounts for 77 percent of the variance premium, and 40 percent of the equity premium.