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Long-Run Risk and Its Implications for the Equity Premium Puzzle: New Evidence from a Multivariate Framework


  • I wish to thank James Morley for making me aware of this subject. I am very grateful to Charles Nelson for his numerous encouragements. I thank Pok-sang Lam (the editor) and an anonymous referee for their insightful comments, which have substantially improved the paper. This paper is derived from one chapter of the author's doctoral dissertation at the University of Washington. I gratefully acknowledge financial support from the Grover and Creta Ensley Fellowship at the University of Washington. I wish to thank Ravi Bansal, John Cochrane, Drew Creal, Michael Dueker, Walter Enders, Scott Gilbert, Dick Startz, Byron Tsang, Stephen Turnovsky, Mark Wohar, and Eric Zivot for helpful comments. I alone am responsible for any error.


This paper investigates the empirical evidence of long-run risk and its implications for the equity premium puzzle. We find that the long-run risk model is generally weakly identified and that standard inferences tend to underestimate the uncertainty of long-run risk. We extend the LM-type test of Ma and Nelson (2010) that remains valid under weak identification to the bivariate VARMA-GARCH model of consumption and dividend growth. The results cast doubt on the validity of long-run risk as an explanation for the equity premium puzzle. We also evaluate the approach of Bansal, Kiku, and Yaron (2007a), which extracts long-run risk by regressing consumption growth and its volatility on predictive variables. The results using the Bonferroni Q-test of Campbell and Yogo (2006) suggest that consumption and dividend growth are generally unpredictable by the price-dividend ratio and risk-free rate. This casts doubt on the validity of the BKY approach.