Long Run Risks, the Macroeconomy, and Asset Prices

Abstract

Ravi Bansal and Amir Yaron (2004) developed the Long Run Risk (LRR) model which emphasizes the role of long run risks, that is, low-frequency movements in consumption growth rates and volatility, in accounting for a wide range of asset pricing puzzles. In this article we present a generalized LRR model, which allows us to study the role of cyclical fluctuations and macroeconomic crises on asset prices and expected returns. The Bansal and Yaron (2004) LRR model contains (i) a persistent expected consumption growth component, (ii) long-run variation in consumption volatility, and (iii) preference for early resolution of uncertainty. To evaluate the role of cyclical risks, we incorporate a cyclical component in consumption growth—this component is stationary in levels. To study financial market crises, we also entertain jumps in consumption growth and volatility. We find that the magnitude of risk compensation for cyclical risks in consumption critically depends on the magnitude of the intertemporal elasticity of substitution (IES). When the IES is larger than one, cyclical risks carry a very small risk premium. When IES is close to zero, the risk compensation for cyclical variations is large; however, in this case the risk-free rate is implausibly high (in excess of 10 percent). It is, therefore, unlikely that the compensation for cyclical risks is of economically significant magnitude. This implication is also consistent Long Run Risks and asset MaRkets †