Ebook Consumption Volatility and the Cross-Section of Stock Returns
The question what door should investors care about? remains central in Asset Pricing and a variety of models continue to provide alternative answers. Investment opportunities are risky and investors face multiple sources of financial and macroeconomic risks that they should hedge themselves against when constructing their portfolios. This paper provides and supports the evidence that long-term investors care not only about variation between future and present consumption levels, but also and perhaps mostly about variation between future and present macroeconomic uncertainties.
As in Bansaland Yaron (2004), macroeconomic uncertainty here refers to the volatility of aggregate consumption. We answer the following question: Are differences in risk premia across stocks due to the hetero geneity in their exposure to consumption volatility risk? We find that portfolios with high risk premia have high negative covariances with long-horizon variation in consumption volatility. This is true for short period investments, as well as for long-period investments. Therefore, it suggests that investors dislike assets paying less for higher future macroeconomic uncertainty relative to the present. Consequently, they will demand a higher risk premium for holding such assets.
The critical consideration that consumption volatility varies over time is central in this study. A recent literature emphasizes that the relationship betwe en macroeconomic uncertainty and investment opportunities is crucial to understand the behavior of asset prices (see for example Bansal and Yaron (2004)). Kandeland Stambaugh (1990) find that consumption volatility is predicted by three financial variables and moreover, it varies in relation with the business cycle.
That is, consumption volatility tends to be larger at the end of recessions or immediately after them. Markov-Switching models estimated on consumption data support that consumption growth volatility varies across different regimes (Kandeland Stam baugh (1991), Bonomoand Garcia (1993), Lettau, Ludvigson and Wachter (2006)). Modelling consumption volatility asa GARCH process, Bansal, Khatchatrian and Yaron (2004) finda significant ARCH effect. They also show that this measure of consumption volatility is predicted by the price dividend ratio.
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