Durable Matters? An Alternative Measure of Consumption Risk

Abstract

Empirical proxies for permanent shocks to durables consumption growth are shown to generate strong pricing implications for both one-period and long-run risk return tradeoff in a cross-section of test assets. This factor is identified as an additional source of consumption risk in a structural model where investors are endowed with recursive preferences over consumption of both durable and nondurable goods whose growth rates are predictable. In the data, small stocks, value stocks and treasury bonds with longer maturities covary more strongly with this factor than big stocks, growth stocks and treasury bonds with shorter maturities, thus generating higher expected return. My estimation implies reasonable magnitude of risk aversion. Next, I apply dynamic value decomposition method in conjunction with my economic model to analyze cash flows from value and growth portfolios. Incorporating durable consumption identifies significant heterogeneity in the stationary component of these cash flows, but only negligible difference in their martingale component. This suggests higher risk premium associated with holding the near end, rather than far end, of cash flow components from value portfolio could be an important contributor to the well known value premium.