Our article comprehensively reexamines the performance of variables that have been suggested by the academic literature to be good predictors of the equity premium. We find that by and large, these models have predicted poorly both in-sample (IS) and out-of-sample (OOS) for 30 years now; these models seem unstable, as diagnosed by their out-of-sample predictions and other statistics; and these models would not have helped an investor with access only to available information to profitably time the market.

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A Comprehensive Look at the Empirical Performance of Equity Premium Prediction

We model dividend and consumption growth rates as containing a small long-run predictable component and economic uncertainty (i.e., growth rate volatility) as being time-varying. The magnitudes of the predictable variation and changing volatility in growth rates, as in the data, are quite small. These growth rate dynamics, for which we provide empirical support, in conjunction with plausible parameter configurations of the Epstein and Zin (1989) preferences can explain key observed asset markets phenomena. In particular, we show that the model can justify the observed equity premium, the low risk free rate, and the ex-post volatilities of the market return, real risk free rate, and the price-dividend ratio. As in the data, the model also implies that dividend yields predict returns and that market return volatility is stochastic. The main economic insight we capture is that news about growth rates significantly alter agent's perceptions regarding long run expected growth rates and growth rate uncertainty--in equilibrium, this leads to a large equity risk premium, low risk free interest rate, and large market volatility.

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. We formalize this intuition with an asset pricing model that incorporates conditional skewness. Our results show that conditional skewness helps explain the cross-sectional variation of expected returns across assets and is significant even when factors based on size and book-to-market are included. Systematic skewness is economically important and commands a risk premium, on average, of 3.60 percent per year. Our results suggest that the momentum effect is related to systematic skewness. The low expected return momentum portfolios have higher skewness than high expected return portfolios.

/pdf/conditional-skewness-in-asset-pricing-tests-3bq6pue1a4.pdf

Conditional Skewness in Asset Pricing Tests

We model consumption and dividend growth rates as containing (1) a small longrun predictable component, and (2) fluctuating 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.

/pdf/risks-for-the-long-run-a-potential-resolution-of-asset-10ezb0a3sk.pdf

Most empirical studies of the static CAPM assume that betas remain constant over time and that the return on the value-weighted portfolio of all stocks is a proxy for the return on aggregate wealth. The general consensus is that the static CAPM is unable to explain satisfactorily the cross-section of average returns on stocks. We assume that the CAPM holds in a conditional sense, i.e., betas and the market risk premium vary over time. We include the return on human capital when measuring the return on aggregate wealth. Our specification performs well in explaining the cross-section of average returns. A SUBSTANTIAL PART OF the research effort in finance is directed toward improving our understanding of how investors value risky cash flows. It is generally agreed that investors demand a higher expected return for investment in riskier projects, or securities. However, we still do not fully understand how investors assess the risk of the cash flow on a project and how they determine what risk premium to demand. Several capital asset-pricing models have been suggested in the literature that describe how investors assess risk and value risky cash flows. Among them, the Sharpe-Lintner-Black Capital Asset Pricing Model (CAPM)1 is the one that financial managers use most often for assessing the risk of the cash flow from a project and for arriving at the appropriate

/pdf/the-conditional-capm-and-the-cross-section-of-expected-1uja8dfxhp.pdf

The Conditional CAPM and the Cross-Section of Expected Returns

https://faculty.fuqua.duke.edu/~rb7/bio/JIE2000.pdf

The forward premium puzzle: different tales from developed and emerging economies

We show that aggregate consumption risks embodied in cash flows can account for the puzzling differences in risk premia across book-to-market, momentum, and sizesorted portfolios. The dynamics of aggregate consumption and cash flow growth rates, modeled as a vector autoregression, are used to measure the consumption beta of discounted cash flows. Differences in these cash flow betas account for more than 60% of the cross-sectional variation in risk premia. The market price for risk in cash flows is highly significant. We argue that cash flow risk is important for interpreting differences in risk compensation across assets. THE IDEA THAT DIFFERENCES IN EXPOSURE to systematic risk should justify differences in risk premia across assets is central to asset pricing. The static CAPM (capital asset-pricing model) (see Sharpe (1964) and Lintner (1965)) implies that assets’ exposures to aggregate wealth should determine cross-sectional differences in risk premia. The work of Lucas (1978) and Breeden (1979) argues that the risk premium on an asset is determined by its ability to insure against consumption fluctuations. Hence, the exposure of asset returns to movements in aggregate consumption (i.e., the consumption betas) should determine cross-sectional differences in risk premia. Evidence presented in Hansen and Singleton (1982) for the consumption-based models, and in Fama and French (1992) for the CAPM, shows that these models have considerable difficulty in justifying the differences in observable rates of return across assets. Consequently, identifying economic sources of risks that justify differences in the measured risk premia continues to be an important economic issue. Asset prices reflect the discounted value of cash flows; return news, consequently, reflects revisions in expectations about the entire path of future

/pdf/consumption-dividends-and-the-cross-section-of-equity-xevf23ry3b.pdf

Ravi Bansal

Papers

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

The forward premium puzzle: different tales from developed and emerging economies

Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Consumption, Dividends, and the Cross Section of Equity Returns