Long-run Consumption Risk Research Articles

Cross-Country Consumption Risk Sharing, a Long-Run Perspective

This paper estimates an empirical nonstationary panel regression model that tests long-run consumption risk sharing across a sample of OECD and emerging market (EM) countries. This is in contrast to the existing literature on consumption risk sharing, which is mainly about risks at business cycle frequency. Since our methodology focuses on identifying cointegrating relationships while allowing for arbitrary short-run dynamics, we can obtain a consistent estimate of long-run risk sharing while disregarding any short-run nuisance factors. Our results show that long-run risk sharing in OECD countries increased more than that in EM countries during the past two decades.

Long-Run Consumption Risk and the Real Yield Curve

This paper estimates a consumption-based, no-arbitrage model of the term structure of real interest rates. The model nests the standard long-run risk model which assumes constant market prices of risk. We find that the long-run consumption risk dominates the short-run and volatility risks and drives most of the movements of bond risk premiums. The risk premium for consumption volatility is negative, suggesting that long-term real bonds provide an effective hedge against the volatility risk in consumption growth. In contrast to the standard long-run risk model, however, we find strong evidence that the market price of long-run consumption risk is time-varying and that stochastic volatilities alone are not sufficient to account for the variations in bond risk premiums.

Long-run Consumption Risk and International Stock Returns: A Century of Evidence

We estimate consumption based asset pricing models using consumption and equity market data for fifteen countries from 1900 to 2008 in a setting where investors have recursive utility. We find strong evidence that a long-run risk consumption CAPM that prices international stock returns via their exposures to multi-period consumption growth in world consumption performs considerably better in explaining the international cross-section of returns than the canonical consumption CAPM. By virtue of the long-run data set, we are also able to relate the importance of world consumption risk for the cross-section of international stock returns to periods of high and low capital market integration. It turns out that the extent to which returns are exposed to world consumption growth indeed di ffers across periods: During the early part of our sample period, when international capital mobility was high, stock returns' exposure to world consumption growth is important. Local consumption growth, however, is more important for the post-WWII period when international capital mobility was generally low except for the last two decades.

Growth to Value: Option Exercise and the Cross-Section of Equity Returns

We put forward an equilibrium model that links the cross-sectional variation in expected equity returns to firms' life cycle dynamics. The model features two sources of risks: short and long-run fluctuations in aggregate consumption, as in Bansal and Yaron (2004). Growth assets in the model are options on assets in place (i.e., value assets). The cost of option exercise, endogenously determined in equilibrium, is highly sensitive to long-run consumption risks. This provides a hedge against risks in assets in place, making growth options less risky and generating the value premium. The model is also able to endogenize the size premium: small firms in the model are highly exposed to low-frequency consumption risks as they are more likely to fail in bad times; hence, in equilibrium, small firms carry a high risk premium. In the model, the null hypothesis of the conditional CAPM/CCAPM fails: the value and size effects persist even after controlling for market risk or exposure to contemporaneous consumption innovations. We calibrate the model and show that it is able to account for the observed patterns in mean returns on book-to-market and size sorted portfolios, as well as the failure of the CAPM/CCAPM in the data.

Global Asset Pricing: Is There a Role for Long-Run Consumption Risk?

We estimate long-run consumption-based asset pricing models using a comprehensive set of international test assets, including broad equity market portfolios, international value/growth portfolios, and international bond portfolios. We find that differences in returns across assets within a country are sometimes (and most prominently for the U.S.) better captured by the assets' exposure to long-run consumption risk as opposed to their exposure to one-period changes in consumption (the canonical consumption CAPM). Across countries, however, exposure to long-run consumption risk does not provide a better fit than the canonical consumption CAPM. Thus, when characterizing the cross-country distribution of returns, long-run consumption risk does not seem to play any particular role, even if long-run risk is important for explaining the cross section of expected returns in the U.S. Furthermore, we show that consumption growth is more predictable over short to medium-run horizons than over longer horizons and that empirical evidence of a declining risk aversion parameter estimate in long-run risk models has to be interpreted with care.

Rational Inattention, Long-Run Consumption Risk, and Portfolio Choice

This paper explores how the introduction of rational inattention (RI) -- that agents process information subject to finite channel capacity -- affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the asset return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium.

Intertemporal Substitution and Equity Premium: A Perspective with Habit in Epstein-Zin Preferences

This paper presents a consumption based model that reveals intertemporal substitution as a distinctive and important channel, separate from risk aversion, in generating equity premium, return volatility, and their cyclical variations. Two main ingredients, Epstein-Zin preferences and external habit, allow the model to distinguish the separate effects of intertemporal substitution and risk aversion. The results indicate an effective elasticity of intertemporal substitution that is much lower than the parameter value and varies procyclically. On the other hand, the effective risk aversion is counter-cyclical and much higher than the parameter value. To match the empirical statistics of the post-war U.S. stock market, the model critically requires a small elasticity parameter below 1. This points to an interesting contrast between the habit formation and the long-run consumption risk models.

The Long-Run World Consumption Risk of International Stock Markets

A salient characteristic of recent developments in international financial markets is that the share of international assets in investors' portfolios has increased. Taking the increase in international integration and consumption risk sharing among industrialized countries as given, this paper estimates the risk-aversion coefficient of a representative global investor who is concerned about the world consumption risk inherent in excess returns from different stock markets. The paper examines both traditional consumption risk and, as the novel aspect of the paper, long-run consumption risk, which is the exposure of excess returns to current-period plus future period changes in world consumption. This paper finds that the risk-aversion coefficient of the global investor can be brought down from an estimated value of around 100 in the traditional setting to less than 20 for the global investor who also takes long-run world consumption risk into account.

Long-Run Consumption Risk and the Real Yield Curve

Long-Run Consumption Risk and the Real Yield Curve

Cointegration and Consumption Risks in Asset Returns

We argue that the cointegrating relation between dividends and consumption, a measure of long-run consumption risks, is a key determinant of risk premia at all investment horizons. As the investment horizon increases, transitory risks disappear, and the asset’s beta is dominated by long-run consumption risks. We show that the return betas, derived from the cointegration-based VAR (EC-VAR) model, successfully account for the cross-sectional variation in equity returns at both short and long horizons; however, this is not the case when the cointegrating restriction is ignored. Our evidence highlights the importance of cointegration-based long-run consumption risks for financial markets. (JEL G1, G12) How does the riskiness of equity returns change with investment horizon? We show that at long horizons, risks are dominated by long-run consumption risks in dividends, while at short horizons, additional price risks may also matter. The cointegrating relation between dividends and consumption (i.e., the longrun consumption beta of dividends) provides a measure of long-run risks in dividends. This cointegrating relation has important conceptual and empirical implications for measuring risks in asset returns at all horizons. Empirically, we document that consumption betas determined by the cointegrationbased vector-autoregression (EC-VAR) can account for the cross section of mean equity returns at both short and long horizons. This, however, is not the case when the cointegration restriction between consumption and dividends is ignored. Hence, our evidence highlights the economic importance of long-run

Long-Run Risk Through Consumption Smoothing

We examine how long-run consumption risk arises endogenously in a standard production economy model where the representative agent has Epstein-Zin preferences. Even when technology growth is i.i.d., optimal consumption smoothing induces highly persistent time-variation in expected consumption growth (long-run risk). This increases the price of risk when investors prefer early resolution of uncertainty, and the model can then account for the low volatility of consumption growth and the high price of risk with a low coefficient of relative risk aversion. The asset price implications of endogenous long-run risk depends crucially on the persistence of technology shocks and investors preference for the timing of resolution of uncertainty. We use the time-series of consumption growth and the cross-section of stock returns to evaluate different parameterizations of the model.

Time-Varying Exposure to Long-Run Consumption Risk

This paper develops a model of time-varying expected returns and shows that, when investors care about the long-run consumption risk, they also care about the persistence of an asset's exposure to this risk, and demand substantially higher compensation for more persistent exposure. The model also implies a negative sensitivity of price-dividend ratios to expected excess returns, and the magnitude of the sensitivity is substantially larger for more persistent exposure. In an application of the model, I specify individual stocks' dividend growth as containing two time-varying components of exposure to the long-run consumption risk - a fast mean-reverting component whose shocks are positively correlated with the independent dividend growth shocks, and a slow mean-reverting component whose shocks are negatively correlated with the independent dividend growth shocks. Firm level simulations from this model produce short-run momentum and long-run reversal quantitatively comparable to empirically documented patterns in the cross section as well as along the time dimension. The simulations also show that the value premium across price-dividend ratio sorted portfolios is driven by a spread in the slow mean-reverting risk exposure. Together, these results propose potential interpretations of the value and momentum factors as representing time-varying loadings of different persistence on the long-run consumption risk factor.