Long-Run Risk through Consumption Smoothing

Abstract

We examine how long-run consumption risk arises endogenously in a standard production economy model where the representative agent has Epstein--Zin preferences. We show that even when technology growth is i.i.d., optimal consumption smoothing induces long-run risk--highly persistent variation in expected consumption growth. As a consequence, the model can account for a high price of risk, although both consumption growth volatility and the coefficient of relative risk aversion are low. The asset pricing implications of endogenous long-run risk depend crucially on the persistence of technology shocks and investors' preference for the timing of resolution of uncertainty. (JEL E21, E23, E30, G12) The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.