Predictability in Consumption Growth and Equity Returns: A Bayesian Investigation

Authors


  • We thank Fuyu Angela Yang and seminar participants at the 2007 Athens Institute for Education and Research Finance Conference, the 2007 FMA Conference, and the 2007 International Congress on Modeling and Simulation, Christchurch, New Zealand for helpful comments and discussions. We thank also Arnie Cowan (a former editor) and two anonymous referees for constructive comments and suggestions. Any errors are our responsibility.

* Corresponding author: University of Manitoba, I.H. Asper School of Business, 476-181 Freedman Crescent, Winnipeg MB, Canada R3T 5V4; Phone: (204) 474-8353; Fax: (204) 474-7545; E-mail: paseka@cc.umanitoba.ca.

Abstract

We use a Bayesian method to estimate a consumption-based asset pricing model featuring long-run risks. Although the model is generally consistent with consumption and dividend growth moments in annual data, the conditional mean of consumption growth (a latent process) is not persistent enough to satisfy the restriction that the price-dividend ratio be an affine function of the latent process. The model also requires relatively high intertemporal elasticity of substitution to match the low volatility of the risk-free return. These two restrictions lead to the equity volatility puzzle. The model accounts for only 50% of the total variation in asset returns.

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