Asset Pricing with Long-Run Risk in Leisure and Consumption

Abstract

I document that leisure growth is persistent, exhibits strong time-varying volatility, and is negatively correlated with both consumption and dividend growth. These empirical properties motivate the dynamics for the three growth rates as containing a common, persistent expected component, driven by shocks of persistent time-varying volatility following a discrete-time CIR process. I embed these dynamics in a model in which the service of leisure is augmented by aggregate consumption, and identical agents exhibit non-separable Epstein-Zin preferences. The model is able to explain major asset market phenomena. Incorporating leisure considerably reduces the effect of long-run growth risk on asset prices, but introduces strong long-run volatility risk, which accounts for about 77% of equity premium in the model. Consistent with the model implications, leisure growth volatility predicts future excess stock returns with positive and significant slopes.