Confidence Risk and Asset Prices

Abstract

To give empirical content to the model, we directly measure confidence from the cross-section of forecasts from the Survey of Professional Forecasters. We show that there are frequent large moves in the confidence measure in the data. Moreover, in the data, these large moves are contemporaneously highly correlated with large moves in asset returns, highlighting the importance of confidence risk for asset prices. For our quantitative analysis, we calibrate the model to the observed confidence risk and con sumption data. We find that the model can quan titatively account for the negatively skewed and heavy-tailed distribution of returns, even though consumption growth does not contain jumps. Exploiting the fluctuations in confidence risks, we show that the model can capture short and long horizon predictability of excess returns and lack of consumption predictability by price to dividend ratio. Further, large moves in the con fidence measure lead to large declines (negative jumps ) in asset prices, though there are no large moves in consumption. Hence, our model pro vides a mechanism to account for the lack of connection between large asset price moves and consumption fundamentals. I. Model Set-up