Consumption Volatility and the Cross-Section of Stock Returns*

Abstract

Interesting asset pricing properties of consumption volatility have been put forward in earlier studies, but they were mainly related to the time series dimension of asset returns. A major contribution of this paper will be to characterize and measure its impact in the cross-sectional dimension. We establish empirical facts showing the existence of a strong relationship between macroeconomic uncertainty and stock returns. These facts suggest that consumption volatility risks are highly correlated to short and long horizon risk premia. Moreover, these risks can account for the differences in risk premia across size and book-to-market sorted portfolios, as well as other valuation ratio sorted portfolios. We find that long-run consumption volatility risk is economically important even in the presence of long-run consumption level risk, and that value stocks pay high average returns because they covary more negatively with long-horizon variation in consumption volatility than other stocks. We argue that long-run volatility risk is relevant for interpreting differences in risk compensation across assets. We finally propose a reduced-form general equilibrium model that rationalizes the empirical evidence.