Risk for Long Run

THE JOURNAL OF FINANCE • VOL. LIX, NO. 4 • AUGUST 2004

Risks for the Long Run: A Potential Resolution

of Asset Pricing Puzzles

RAVI BANSAL and AMIR YARON∗

ABSTRACT

We model consumption and dividend growth rates as containing (1) a small longrun predictable component, and (2) f luctuating economic uncertainty (consumption

volatility). These dynamics, for which we provide empirical support, in conjunction

with Epstein and Zin’s (1989) preferences, can explain key asset markets phenomena.

In our economy, financial markets dislike economic uncertainty and better long-run

growth prospects raise equity prices. The model can justify the equity premium, the

risk-free rate, and the volatility of the market return, risk-free rate, and the price–

dividend ratio. As in the data, dividend yields predict returns and the volatility of

returns is time-varying.

SEVERAL KEY ASPECTS OF ASSET MARKET DATA pose a serious challenge to economic

models.1 It is difficult to justify the 6% equity premium and the low risk-free

rate (see Mehra and Prescott (1985), Weil (1989), and Hansen and Jagannathan

(1991)). The literature on variance bounds highlights the difficulty in justifying the market volatility of 19% per annum (see Shiller (1981) and LeRoy and

Porter (1981)). The conditional variance of the market return, as shown in

Bollerslev, Engle, and Wooldridge (1988), f luctuates across time and is very

persistent. Price–dividend ratios seem to predict long-horizon equity returns

(see Campbell and Shiller (1988)). In addition, as documented in this paper,

consumption volatility and future price–dividend ratios are significantly negatively correlated—a rise in consumption volatility lowers asset prices.

∗ Bansal is from the Fuqua School of Business, Duke University. Yaron is from The Wharton

School, University of Pennsylvania. We thank Tim Bollerslev, Michael Brandt, John Campbell, John

Cochrane, Bob Hall, John Heaton, Tom Sargent, George Tauchen, the Editor, an...