Aggregate Consumption Growth Research Articles

The Credit Risk Premium and Return Predictability in High Yield Bonds

I demonstrate that much of the time series variation in the credit spread on high yield bonds is attributable to changes in the “credit risk premium” rather than changes in expected default losses. The credit risk premium is the expected excess return investors earn from bearing default risk on high yield bonds. I find that the credit risk premium on high yield bonds averages about 2.4 percent per year, accounts for 43 percent of high yield credit spreads, on average, and predicts excess returns on high yield bonds. I also find that the excess returns on lower rated credits (B and CCC, relative to BB) are more sensitive to variation in the credit risk premium. The credit risk premium increases with the conditional volatility of default losses and decreases with aggregate consumption growth. The evidence suggests that conventional measures of economic risk are able to explain the sizeable increase in credit spreads in the fall of 2008.

Frequency of Consumption Adjustment and the Equity Premium

We show that two types of consumption risk are priced in the equity premium: the risk of aggregate consumption growth and that of changing the composition of the consumption basket, when goods have heterogeneous costs of adjustment. We use the property that the frequency of consumption adjustment is inversely related to adjustment costs and split consumption into two components that proxy for consumption of low and high adjustment cost goods. We then estimate a version of the CCAPM with two components of consumption and show that our proposed split helps resolve the equity premium puzzle, while simultaneously generating sufficient volatility of marginal utility to satisfy volatility bounds at all frequencies.

Asset Pricing Tests with Long-run Risks in Consumption Growth

The Bansal and Yaron (2004) model of long run risks (LLR) in aggregate consumption and dividend growth and its extension that captures potential cointegration of the consumption and dividend levels, are tested on a cross-section of asset classes and rejected using annual data over the period 1930-2006 and using both annual and quarterly data over the post-war period. The reversal of earlier empirical conclusions is partly due to the increase in the power of the tests resulting from two observations under the null. First, the latent state variables and, therefore, the pricing kernel are known a¢ ne functions of observables such as the interest rate and the market-wide price-dividend ratio. Second, the parameters of the time-series processes of consumption and dividend growth, the LLR variable, and its conditional variance impose constraints on the parameters of the pricing kernel. The value of the persistence parameter of the LRR variable that best …ts the data implies that its half-life is shorter than that of the business cycle.

Asset Pricing with Concentrated Ownership of Capital

This paper investigates how concentrated ownership of capital in‡uences the pricing of risky assets in a production economy. The model is designed to approximate the skewed distribution of wealth and income in U.S. data. I show that concentrated ownership significantly magni…es the equity risk premium relative to an otherwise similar representativeagent economy because the capital owners’consumption is more strongly linked to volatile dividends from equity. A temporary shock to the technology for producing new capital (an “investment shock”) causes dividend growth to be much more volatile than aggregate consumption growth, as in long-run U.S. data. The investment shock can also be interpreted

Economic Uncertainty, Disagreement, and Credit Markets

We study how the equilibrium risk-sharing of agents with heterogenous perceptions of aggregate consumption growth affects bond and stock returns. While credit spreads and their volatilities increase with the degree of heterogeneity, the decreasing risk premium on moderately levered equity can produce a violation of basic capital structure no-arbitrage relations. Using bottom-up proxies of aggregate belief dispersion, we give empirical support to the model predictions and show that risk premia on corporate bond and stock returns are systematically explained by their exposures to aggregate disagreement shocks.

Oil Prices and Long-Run Risk

I show that relative levels of aggregate consumption and personal oil consumption provide an excellent proxy for oil prices, and that high oil prices predict low future aggregate consumption growth. Motivated by these facts, I add an oil consumption good to the long-run risk model of Bansal and Yaron [2004] to study the asset pricing implications of observed changes in the dynamic interaction of consumption and oil prices. In the model, oil prices are implied by the agent’s rst order condition, and expected consumption growth is driven by two distinct factors: the oil price and a separate predictable component of growth. Empirically I observe that, over the rst half of my 1987 - 2010 sample, increases in these factors predict high future oil consumption growth. More recently, I observe that expected oil consumption growth has no response to either factor. The model predicts that this change in consumption dynamics implies changes in risk which generate a hump shaped term structure of oil futures, consistent with recent data. Additionally, the model predicts a change in the conditional relation of aggregate consumption volatility, oil price volatility, and the term structure of oil futures. I also nd evidence for this in the data. Finally, the model implies that the change in the dynamics of oil consumption implies increased systematic risk from oil price shocks, but reduces the risk from shocks to expected consumption growth. The combined eect is to reduce overall consumption risk and lower the equity premium.

Financial Integration and Risk Sharing in the East African Community

This study explores the link between financial integration and risk sharing in the East African Community [EAC]. It empirically tests the standard risk sharing hypothesis that consumption growth rates of individual countries should be perfectly correlated with the average consumption growth rate and not the individual country income in the financially integrated area. It then links the level of risk sharing to the level of financial integration to determine how the two interact. Finally, risk sharing and financial integration are jointly considered after taking into account the stochastic properties of income growth, particularly the permanent and transitory components of income and their shocks and how these interact with financial integration to improve risk sharing. The results indicate less than efficient risk sharing in the EAC. Standard tests reject the risk sharing hypothesis but show strong correlation between individual country consumption growth rates and aggregate consumption growth in the EAC. However, when financial integration is accounted for, this effect disappears and consumption growth only responds to income growth. This result is considered as indicating the equivalence of financial integration to expected consumption growth. When the different components of the income process and their shocks are taken into account, results suggest that financial integration helps EAC countries achieve insurance against shocks to the transitory component of income. The overall results indicate that as financial integration in the EAC improves, there should be increased risk sharing and hence smoother consumption growth over time.

When is market incompleteness irrelevant for the price of aggregate risk (and when is it not)?

In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In equilibrium, households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore, the cross-sectional distributions of wealth and consumption are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, even when households face tight solvency constraints. A weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.

The Market Price of Aggregate Risk and the Wealth Distribution

We introduce limited liability in a model with a continuum of ex ante identical agents who face aggregate and idiosyncratic income risk. These agents can trade a complete menu of contingent claims, but they cannot commit to honor their promises, and their shares in a Lucas tree serve as collateral to back up their state-contingent promises. The limited-liability option gives rise to a second risk factor, in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints, and it is measured by the growth rate of one moment of the wealth distribution. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. The adjustment to the Breeden-Lucas stochastic discount factor induces substantial time variation in equity risk-premims that is consistent with the data at business cycle frequencies. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Structural Uncertainty, Learning, and Asset Pricing

We examine the effects of parameter uncertainty and Bayesian learning on equilibrium asset prices when all the structural parameters of the aggregate consumption and dividend growth rate processes are unknown. With realistic calibration of a parsimonious set of prior parameters, the model generates a sizeable equity premium and a low risk-free rate even with a power utility function, low risk aversion, and absence of persistence in growth rates. Raising the prior uncertainty on consumption growth induces a flight to safety that results in lower risk-free rates, higher equity premium, and greater risk-free rate volatility. But raising the prior uncertainty on dividend growth rates has ambiguous effects on the equity premium. Learning does not produce a monotonically declining equity premium and shocks to growth rates can induce sharp fluctuations in the market returns even after one hundred years of data. Finally, the effects of persistence in growth rates on the market returns are highly sensitive to the prior estimates of persistence.

Consumption and Income Relationship: Non-Linearity, Cyclicity and Persistence

We develop a Neo-Classical growth model with habit formation to exhibit an equilibrium non-linear relationship between aggregate consumption growth and income growth. We provide empirical evidence consistent with this relationship both for the U.S. and France, and we estimate this non-linear relationship. We find for both countries robust evidence of persistence and cyclicity.

Differences of Opinion and the Price Volume Relation

This paper solves a dynamic general equilibrium asset pricing model of disagreement that draws a direct link between asset prices and the financial volume of trade. The model exhibits two risk averse agents that hold heterogeneous beliefs about the conditional mean of the aggregate consumption growth. The differences in opinions is supported by the fact that agents interpret public information differently. The connecting link between prices and volume is an exogenously time varying disagreement intensity that determines the magnitude of disagreement about new information. The model is able to explain a number of seemingly unrelated asset pricing facts namely the positive correlation between price changes and volume, the contemporaneous relation between volume and return volatility, the excess volatility, the volatility persistence and the negative correlation between price levels and volatility.

Diverse Beliefs, Survival and the Market Price of Risk

We study prices and allocations in a complete-markets, pure-exchange economy in which there are two types of agents with different priors over infinite sequences of the aggregate endowment. Aggregate consumption growth evolves exogenously according to a two-state Markov process. The economy has two types of agents, one that learns about transition probabilities and another that knows them. We examine allocations, the market price of risk and the rate at which asset prices converge to values that would be computed under the assumption that all agents know the transition probabilities. Cogley and Sargent (2008) showed that market prices of risk would be high in an economy with a risk-neutral Bayesian representative agent who learns about the parameters of a transition matrix for aggregate consumption growth starting with a pessimistic prior in 1933.1 This article studies the robustness of that finding to a per turbation that adds a small fraction of agents who know the parameters of the trans ition matrix. Traders participate in a Walrasian equilibrium in which they do not infer information from prices (Grossman, 1981).23 Under what we assume to be the true data-generating mechanism, the survival-of-the-fittest force analysed by Blume and Easley (2006) causes the more knowledgeable agents' influence on equilibrium prices to grow over time along with their wealth. We study how quickly that dissipates the effects of the initial pessimism of the less informed agents on equilibrium prices.4 To give the survival mechanism a large scope to moderate the effects of initial pessim ism, we assume complete markets that allow agents to make trades of claims to wealth that are motivated solely by the different subjective probabilities they put on future states. That gives the agents many opportunities to place bets that over time stochastically increase the share of wealth of the traders who know transition probabilities. We solve a Pareto problem to compute competitive equilibrium prices and alloca tions, thereby implicitly defining an initial allocation of wealth. We study how the market price of risk evolves as a function of the relative Pareto weight on the better informed agent. Among other things, we want to know how large the Pareto weight on

Who Bears Aggregate Fluctuations and How?

The consumption of high-consumption households is more exposed to fluctuations in aggregate consumption and income than that of low-consumption households in the Consumer Expenditure (CEX) Survey. The exposure to aggregate consumption growth of households in the top 10 percent of the consumption distribution in the CEX is about five times that of households in the bottom 80 percent. Given real aggregate per capita consumption growth about 3 percentage points less than its historical mean during the past year, these figures predict that the ratio of consumption of the top 10 percent to the bottom 80 percent has fallen by about 15 percentage points (relative to trend). Using income data from Piketty and Saez (2003), we show that the income (especially the wage income) of rich households is more exposed to aggregate fluctuations, so their higher income exposure is a likely contributor to their higher consumption exposure. Finally, we find a striking change in the exposure of the incomes of high-income households: prior to the early 1980's, the incomes of high-income households were not more exposed to aggregate fluctuations. Thus, while high-income households currently bear an inordinately large share of aggregate fluctuations, this is a recent occurrence.

Euler equation errors

The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross-sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

Economic Uncertainty, Disagreement, and Credit Markets

We study how the equilibrium risk sharing of agents with heterogeneous perceptions of aggregate consumption growth affects bond and stock returns. Although credit spreads and their volatilities increase with the degree of heterogeneity, the decreasing risk premium on moderately levered equity can produce a violation of basic capital structure no-arbitrage relations. Using bottom-up proxies of aggregate belief dispersion, we give empirical support to the model predictions and show that risk premia on corporate bond and stock returns are systematically explained by their exposures to aggregate disagreement shocks. This paper was accepted by Jerome Detemple, finance.

Environmental Policy, Education and Growth: A Reappraisal when Lifetime is Finite

This article demonstrates that when finite lifetime is introduced in a Lucas (1988) growth model, the environmental policy may enhance growth both in the short- and the long-run, while pollution does not influence educational activities, labor supply is not elastic and human capital does not enter the utility function. This is because finite lifetime and the appearance of newborns at each date creates a turnover of generations which disconnects the aggregate consumption growth to the interest rate. We show that the shorter is the horizon, the greater the of the environmental policy on growth, because the higher the generational turnover effect. We also demonstrate that when time is not the single production factor in education, the environmental policy promotes growth only if time remains the predominant factor. Otherwise, the crowding-out of the tighter environmental policy dominates the generational turnover effect and growth diminishes. Finally, when the source of pollution is final output rather than physical capital and time is the single factor in education, the environmental does not affect growth in the steady-state, despite the generational turnover effect. Nevertheless, if the education good is introduced, the positive influence of the environmental policy appears again.

Evaluating Asset Pricing Models with Limited Commitment Using Household Consumption Data

We evaluate the asset pricing implications of a class of models in which risk sharing is imperfect because of limited enforcement of intertemporal contracts. Lustig (2004) has shown that in such a model the asset pricing kernel can be written as a simple function of the aggregate consumption growth rate and the growth rate of consumption of the set of households that do not face binding enforcement constraints. These unconstrained households have lower consumption growth rates than all other households in the economy. We use household data on consumption growth from the U.S. Consumer Expenditure Survey to identify unconstrained households, to estimate the pricing kernel implied by these models and evaluate their performance in pricing aggregate risk. We find that for high values of the relative risk aversion coecient, the limited enforcement

International Evidence on Sticky Consumption Growth

This paper estimates the degree of stickiness in aggregate consumption growth (sometimes interpreted as reflecting consumption habits) for thirteen advanced economies. We find that after controlling for measurement error, consumption growth has a high degree of autocorrelation, with a stickiness parameter of about 0.7 on average across countries. The sticky consumption growth model outperforms the random walk model of Hall (1978) and typically fits the data better than the popular Mankiw (1989) model, though in a few countries, the sticky consumption growth and Campbell-Mankiw models work about equally well.

Consumption Heterogeneity and Long Run Risk

This paper establishes a surprising and robust empirical similarity between short-run heterogeneous consumption and long-term consumption growth risk models. The models not only deliver a similar fit on a given set of portfolios, their actual pricing errors are also highly correlated. In addition, we find that consumption dispersion is a robust predictor of the transitory component in aggregate consumption growth. To interpret these findings, we propose a model in which aggregate uncertainty is a function of idiosyncratic uncertainty and only long-term consumption growth risk is priced. An implication of this being that consumption dispersion is priced empirically not because markets are necessarily incomplete but because investors disagree in the short-run about their common long-term consumption prospects.