scispace - formally typeset
Search or ask a question
Journal ArticleDOI

A Consumption-Based Model of the Term Structure of Interest Rates

TL;DR: This paper proposed a consumption-based model that can account for many features of the nominal term structure of interest rates, such as a time-varying price of risk generated by external habit.
Abstract: This paper proposes a consumption-based model that can account for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated data on consumption, inflation, and the average level of bond yields, the model produces realistic volatility of bond yields and can explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and Fama and Bliss (1987). When Actual consumption and inflation data are fed into the model, the model is shown to account for many of the short and long-run fluctuations in the short-term interest rate and the yield spread. At the same time, the model captures the high equity premium and excess stock market volatility.

Summary (4 min read)

Introduction

  • The negative correlation between surplus consumption and the riskfree rate leads to positive risk premia on real bonds, and an upward sloping yield curve.
  • Expected inflation is calibrated purely to match inflation data.
  • Like these models, the model proposed here assumes that the agent evaluates today’s consumption relative to a reference point that increases with past consumption.

1 Model

  • This section describes the model assumed in this paper.
  • Section 1.1 describes the assumptions for preferences, Section 1.2 describes the assumptions on the price level.
  • Section 1.3 describes the solution method, and Section 1.4 discusses consequences for risk premia on real and nominal bonds.

1.1 Preferences

  • The sensitivity function λ(st) will be described below.
  • In the model of Campbell and Cochrane (1999), the mechanism in (10) does not create timevarying risk premia on bonds for the simple reason that bond returns are constant, and equal to the riskfree rate at all maturities.

1.2 Inflation

  • For simplicity, the authors follow Boudoukh (1993) and Cox, Ingersoll, and Ross (1985), and model inflation as an exogenous process.
  • The correlation between inflation, Zt and consumption can be modeled in a parsimonious way by writing the consumption growth shock vt+1 as vt+1 = σc²t+1.
  • This structure allows for an arbitrary number of state variables and cross-correlations.
  • Multiple lags may be accommodated by increasing the dimension of Zt. 5Harvey (1989) provides direct evidence that the the risk-return tradeoff varies counter-cyclically.
  • 6Since an earlier version of this paper circulated, Buraschi and Jiltsov (2003) study a related model that puts the money supply directly in the utility function.

1.3 Model Solution

  • This section calculates the prices of long-term bonds and stocks.
  • To compute prices on nominal bonds, techniques from affine bond pricing7 are combined with numerical methods.
  • Introducing affine bond pricing techniques improves the efficiency of the calculation and provides insight into the workings of the model.

Bond Prices

  • This paper solves for prices of both real bonds (bonds whose payment is fixed in terms of units of the consumption good) and nominal bonds (bonds whose payoff is fixed in terms of units of the price level).
  • This implies the boundary condition: P0,t = 1.
  • For this problem, numerical integration is superior to calculating the expectation by Monte Carlo.
  • Equation (14) indicates that, unlike real bond prices, nominal bond prices are functions of the state variable Zt as well as st.
  • These formulas can also be used to gain insight into the workings of the model, as explained in Section 1.4.

Aggregate Wealth

  • The market portfolio is equivalent to aggregate wealth, and the dividend equals aggregate consumption.
  • The price-consumption ratio and the return on the market can be calculated using methods similar to those above, with a small but important modification.
  • Because these assets pay no coupons, they have the same recursive pricing relation as bonds (16).
  • Of course the prices are different, and this is because there is a different boundary condition: P e0,t = Ct. 1.
  • This formula can be solved recursively using one-dimensional quadrature.

1.4 Implications for bond risk premia

  • Of interest is the risk premium on the nominal riskfree asset.
  • If σπσc < 0, the one-period nominal bond has a positive risk premium relative to the one-period real bond.
  • Intuitively, this is because σπσ ′ c < 0 implies that inflation and consumption growth are negatively correlated.
  • In general, there is no closed form expression for nominal or real bond prices with maturity greater than one period.
  • These can be determined in some special cases, as described below.

Special cases

  • As long as expected inflation varies, the nominal riskfree rate also varies.
  • These risk premia vary with st, and it is again not possible to solve for bond prices in closed form.
  • Then inflation risk is not priced, and the same reasoning as above shows that P $n,t = exp{−nrf} exp{An +BnZt}.
  • Thus risk premia on nominal bonds are zero except for a constant Jensen’s inequality term.

2 Estimation

  • The results of the previous section suggest that the process assumed for expected inflation will be an important determinant of yields and returns on nominal bonds.
  • This is equivalent to assuming that realized inflation follows an ARMA(1,1) process.
  • Equations (26)–(28) imply an exact likelihood function.
  • The left column reports the parameter estimate, the right column reports the standard error.

3 Implications for Asset Returns

  • This section describes the implications of the model for returns on bonds and stocks.
  • Section 3.1 describes the calibration of the parameters, and the data used to calculate moments of nominal bonds for comparison.
  • Section 3.2 characterizes the price-dividend ratio and the yield spread on real and nominal bonds as functions of the underlying state variables st and expected inflation.
  • Section 3.3 evaluates the model by simulating 100,000 quarters of returns on stocks and nominal and real bonds and compares the simulated moments implied by the model to those on stocks and nominal bonds in the data.
  • Lastly, Section 3.4 shows the implications of the model for the time series of the short-term interest rate and the yield spread, and examines the properties of implied bond risk premia using the technique proposed by Dai and Singleton (2002).

3.1 Calibration

  • The processes for consumption and inflation are calibrated using the estimation of Section 2, while the preference parameters are calibrated using bond and stock returns.9.
  • Then σc and σπ can be found by taking the Cholesky decomposition of the right hand side of (29).
  • Boudoukh fits consumption and inflation parameters to consumption and inflation data, and preference parameters to bond returns.
  • This implies that when the nominal riskfree rate in the model is evaluated at s̄, it equals the yield on the three-month bond.
  • The simulation results in Section 3.3 show that the difference is small.

3.2 Characterizing the Solution

  • As shown in Figure 3, the price-dividend ratio increases with surplus consumption St. As the pricedividend ratio is often taken to be a measure of the business cycle (e.g. Lettau and Ludvingson (2001)), this confirms the intuition that St is a procyclical variable.
  • 10A potential concern with this regression is the relatively high degree of persistence in the surplus consumption ratio.
  • 16 Figure 4 plots the yields on nominal and real bonds for maturities of three months and ten years.
  • Both nominal and real yields decrease with St, but the long yields are more sensitive to St than the short yields.
  • Both long and short-term yields are increasing in expected inflation.

3.3 Simulation

  • To evaluate the predictions of the model for asset returns, 100,000 quarters of data are simulated.
  • Prices of the claim on aggregate consumption , of real, and nominal bonds are calculated numerically, using the method described in Section 1.3.

Returns on the Aggregate Market

  • Table 3 shows the implications of this model for equity returns.
  • The implications of the present model for equity returns are nearly identical to those of Campbell and Cochrane (1999).
  • The model fits the mean and standard deviation of equity returns, even though it was calibrated only to match the ratio.
  • The persistence φ is chosen so that the model fits the correlation of the price-dividend ratio by construction.
  • In addition, results available from the author show that price-dividend ratios have the ability to predict excess returns on equities, just as in the data (Campbell and Shiller (1988), Fama and French (1989)), and that declines in the price-dividend ratio predict higher volatility (Black (1976), Schwert (1989), Nelson (1991)).

Bond Returns

  • Table 4 shows the implications of the model for means and standard deviations of real and nominal bond yields.
  • The model produces average nominal yields that are very similar to those in the data for bonds between maturities of 3 months and 5 years.
  • The previous discussion shows that interest rate risk leads both real and nominal bonds to have positive risk premia.
  • This section shows that risk premia are indeed time-varying, and explains why.
  • 17 While the model succeeds in fitting the pattern of the coefficients in the data, the magnitude of the difference between the slope coefficients and one is smaller in the model than in the data.

3.4 Implications for the Time Series

  • The previous section shows the implications of the model for the population values of aggregate market moments, bond yields, and Campbell and Shiller (1991) regression coefficients.
  • Zt, it is possible to calculate the model’s implications for nominal yields.
  • The argument in Section 3.1 shows that this series is equal to Zt. 20For the 3-month nominal yield, (23) is an approximate closed-form expression.
  • 23 the higher frequency movements in the 70s, and overall, the correlation between the yield spread implied by the model and that in the data is .40.
  • 24 Figure 9 plots the coefficients βRn from the regression (36), along with the coefficients βn from (34) found in the data.

4 Conclusion

  • This paper offers a theory of the nominal term structure based on the preferences of a representative agent.
  • Nevertheless, the implied volatility of yields is close to the sample estimates of nominal yield volatility in the data.
  • This suggests that surplus consumption, which, along with expected inflation drives changes in yields in the model, is a determinant of yields in the data.
  • The second test is whether, when the Campbell-Shiller regressions are adjusted by risk premia on bonds implied by the model, the slope coefficients are closer to unity.
  • In summary, the model is able to capture many of the properties of moments of bond returns in the data, and explain much of the time series variation in short and long-term bond yields.

Did you find this useful? Give us your feedback

Figures (13)

Content maybe subject to copyright    Report

"2-:)67-8=3*)227=0:%2-%"2-:)67-8=3*)227=0:%2-%
',30%60=311327 ',30%60=311327
-2%2')%4)67 #,%6832%'908=)7)%6',

3279148-32%7)(3()03*8,)!)61 869'896)3*28)6)783279148-32%7)(3()03*8,)!)61 869'896)3*28)6)78
%8)7%8)7
)77-'%#%',8)6
"2-:)67-8=3*)227=0:%2-%
3003;8,-7%2(%((-8-32%0;36/7%8,88476)437-836=94)22)(9*2')$4%4)67
%683*8,)-2%2')311327%2(8,)-2%2')%2(-2%2'-%0%2%+)1)28311327
)'311)2()(-8%8-32)'311)2()(-8%8-32
#%',8)63279148-32%7)(3()03*8,)!)61 869'896)3*28)6)78%8)7
3962%03*
-2%2'-%0'3231-'7

,884(<(3-36+..@2)'3
!,-74%4)6-74378)(%8 ',30%60=311327,88476)437-836=94)22)(9*2')$4%4)67
36136)-2*361%8-3240)%7)'328%'86)437-836=43&3<94)22)(9

3279148-32%7)(3()03*8,)!)61 869'896)3*28)6)78%8)73279148-32%7)(3()03*8,)!)61 869'896)3*28)6)78%8)7
&786%'8&786%'8
!,-74%4)6463437)7%'3279148-32&%7)(13()08,%8%''39287*361%2=*)%896)73*8,)231-2%08)61
7869'896)3*-28)6)786%8)7!,)(6-:-2+*36')&),-2(8,)13()0-7%8-1):%6=-2+46-')3*6-7/+)2)6%8)(&=
)<8)62%0,%&-831-2%0&32(7()4)2(324%78'3279148-32+63;8,8,639+,,%&-8%2(32)<4)'8)(
-2A%8-32#,)2'%0-&6%8)(83(%8%32'3279148-32-2A%8-32%2(8,)%++6)+%8)1%6/)88,)13()0
463(9')76)%0-78-'1)%27%2(:30%8-0-8-)73*&32(=-)0(7%2(%''39287*368,))<4)'8%8-32749>>0)!,)
13()0%073'%4896)78,),-+,)59-8=46)1-91%2()<')77783'/1%6/)8:30%8-0-8=
-7'-40-2)7-7'-40-2)7
-2%2')?-2%2')%2(-2%2'-%0%2%+)1)28
!,-7.3962%0%68-'0)-7%:%-0%&0)%8 ',30%60=311327,88476)437-836=94)22)(9*2')$4%4)67

The Rodney L. White Center for Financial Research
A Consumption-Based Model of the
Term Structure of Interest Rates
Jessica A. Wachter
27-04

A Consumption-Based Model of the Term Structure
of Interest Rates
Jessica A. Wachter
University of Pennsylvania and NBER
July 9, 2004
I thank Andrew Ang, Ravi Bansal, Michael Brandt, Geert Bekaert, John Campbell, John Cochrane,
Francisco Gomes, Vassil Konstantinov, Martin Lettau, Anthony Lynch, David Marshall, Lasse Pederson,
Andre Perold, Ken Singleton, Christopher Telmer, Jeremy Stein, Matt Richardson, Stephen Ross, Robert
Whitelaw, Yihong Xia, seminar participants at the 2004 Western Finance Association meeting in Vancouver,
the 2003 Society of Economic Dynamics meeting in Paris, and the 2001 NBER Asset Pricing meeting in
Los Angeles, the the NYU Macro lunch, the New York Federal Reserve, Washington University, and the
Wharton School. I thank Lehman Brothers for financial support.
Address: The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104;
Tel: (215) 898-7634; Email: jwachter@wharton.upenn.edu; http://finance.wharton.upenn.edu/˜ jwachter/

A Consumption-Based Model of the Term Structure
of Interest Rates
Abstract
This paper proposes a consumption-based model that can account for many features of the
nominal term structure of interest rates. The driving force behind the model is a time-varying
price of risk generated by external habit. Nominal bonds depend on past consumption growth
through habit and on expected inflation. When calibrated to data on consumption, inflation, and
the average level of bond yields, the model produces realistic volatility of bond yields and can
explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and
Fama and Bliss (1987). When actual consumption and inflation data are fed into the model, the
model is shown to account for many of the short and long-run fluctuations in the short-term interest
rate and the yield spread. At the same time, the model captures the high equity premium and
excess stock market volatility.

Citations
More filters
Journal ArticleDOI
TL;DR: The authors investigated the implications of changes in bond term premiums for economic activity using both a structural model and a reduced-form framework and showed that there is no structural relationship running from the term premium to economic activity.
Abstract: Linearized New Keynesian models and empirical no-arbitrage macro-finance models offer little insight regarding the implications of changes in bond term premiums for economic activity. We investigate these implications using both a structural model and a reduced-form framework. We show that there is no structural relationship running from the term premium to economic activity, but a reduced-form empirical analysis does suggest that a decline in the term premium has typically been associated with stimulus to real economic activity, which contradicts earlier results in the literature.

145 citations

Journal ArticleDOI
TL;DR: In this paper, the authors developed a class of discrete-time, nonlinear dynamic term structure models (DTSMs) under the risk-neutral measure, where the distribution of the state vector Xt resides within a family of discrete time affine processes that nests the exact discrete time counterparts of the entire class of continuous-time models in Duffie and Kan (1996) and Dai and Singleton (2000).
Abstract: This paper develops a rich class of discrete-time, nonlinear dynamic term structure models (DTSMs). Under the risk-neutral measure, the distribution of the state vector Xt resides within a family of discrete-time affine processes that nests the exact discrete-time counter-parts of the entire class of continuous-time models in Duffie and Kan (1996) and Dai and Singleton (2000). Moreover, we allow the market price of risk, linking the risk-neutral and historical distributions of X, to depend generally on the state Xt. The conditional likelihood functions for coupon bond yields for the resulting nonlinear models under the historical measure are known exactly in closed form. As an illustration of our approach, we estimate a three factor model with a cubic term in the drift of the stochastic volatility factor and compare it to a model with a linear drift. Our results show that inclusion of a cubic term in the drift significantly improves the models statistical fit as well as its out-of-sample forecasting performance.

136 citations


Cites background or methods from "A Consumption-Based Model of the Te..."

  • ...Campbell and Cochrane (1999) and Wachter (2005) , for instance, develop DTSMs in which agents’ preferences exhibit external habit formation....

    [...]

  • ...In particular, the literature on integrating DTSMs with linearized neo-Keynesian (\IS-LM" style) macroeconomic models (e.g., Rudebusch and Wu (2008), Hordahl, Tristani, and Vestin (2007), Wu (2005) , and Bekaert, Cho, and Moreno (2006)) has focused exclusively on discrete-time Gaussian DTSMs.4 Arbitrage-free DTSMs are overlaid onto log-linear...

    [...]

  • ...To illustrate our modeling strategy we develop a habit-based model of the term structure of interest rates, starting from the pricing kernel examined in Campbell and Cochrane (1999) (hereafter CC), Wachter (2005) , and Verdelhan (2008)....

    [...]

  • ...Following CC and Wachter (2005) , we assume that agents maximize the utility function:...

    [...]

  • ...As in CC and Wachter (2005) , we assume that the state vector Xt is comprised of the current consumption surplus ratio, st, and current in∞ation rate, …t. Consumption growth, gt, is assumed to be conditionally perfectly correlated with the consumption surplus ratio....

    [...]

Journal ArticleDOI
TL;DR: This paper showed that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data, including sizeable term premia and volatile long-term yields, which have previously been considered puzzling in general equilibrium frameworks.
Abstract: We show that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data, including sizeable term premia and volatile long-term yields, which have previously been considered puzzling in general equilibrium frameworks. At the same time, sample moments of consumption growth and inflation can be fit relatively well. The improved model performance does not arise directly from the presence of nominal rigidities. However, this feature introduces (short-run) monetary non-neutrality, so that monetary policy affects consumption dynamics and bond prices. A high degree of 'interest rate smoothing' in the policy rule is essential for our results. At the core of dynamic macroeconomic models, we find equilibrium relationships which describe the allocation of quantities (e.g. consumption and investment) and, when imperfect competition prevails, the setting of prices. These equations are typically valid across time and across states of nature, and financial assets form the tool that is supposed to ensure their validity. Financial assets are therefore an integral part of macroeconomic models. Any well-specified model should be able to match financial data as well as macro data. It is therefore problematic that microfounded models have had a hard time explaining key features of asset prices. The most famous example of this difficulty is the equity premium puzzle but various features of bond yield data have also been char acterised as puzzling in the literature. A number of papers, including Backus et al. (1989), Donaldson et al. (1990), Den Haan (1995) and Chapman (1997), have con cluded that general equilibrium models cannot generate term premia of a magnitude comparable to what we observe in actual data - and may not even be capable of producing positive term premia. For equity, one could argue that fundamentals (the expected future profitability of individual firms) are unobservable and difficult to evaluate. Equity prices may therefore be thought to be subject to fluctuations disconnected from the real economy (information acquisition, fads, etc.) and one could hope that the inability of macroeconomic models to match equity prices does not represent a signal of misspecification. This argument is more difficult to construct for bonds. Bond yields should ultimately reflect expectations of future monetary policy decisions which, at least in recent years, are arguably more predictable than equity fundamentals. Thus, the ability of macroeconomic models to explain bond prices represents an important test of their empirical performance. In this article, we revisit the relationship between bond prices and macroeconomic fundamentals. Contrary to the papers cited above, that rely on flexible price models, we

134 citations

Journal ArticleDOI
TL;DR: This paper explored the role of investor sentiment in the pricing of a broad set of macro-related risk factors and found that high-risk portfolios with higher risk exposure do not earn higher returns.
Abstract: This study explores the role of investor sentiment in the pricing of a broad set of macro-related risk factors. Economic theory suggests that pervasive factors (such as TFP and consumption growth) should be priced in the cross-section of stock returns. However, when we form portfolios based directly on their exposure to macro factors, we find that portfolios with higher risk exposure do not earn higher returns. More important, we discover a striking two-regime pattern for all 10 macro-related factors: high-risk portfolios earn significantly higher returns than low-risk portfolios following low-sentiment periods, whereas the exact opposite occurs following high-sentiment periods. We argue that these findings are consistent with a setting in which market-wide sentiment is combined with short-sale impediments and sentiment-driven investors undermine the traditional risk-return tradeoff, especially during high-sentiment periods.

131 citations

References
More filters
Journal ArticleDOI
TL;DR: In this article, an exponential ARCH model is proposed to study volatility changes and the risk premium on the CRSP Value-Weighted Market Index from 1962 to 1987, which is an improvement over the widely-used GARCH model.
Abstract: This paper introduces an ARCH model (exponential ARCH) that (1) allows correlation between returns and volatility innovations (an important feature of stock market volatility changes), (2) eliminates the need for inequality constraints on parameters, and (3) allows for a straightforward interpretation of the "persistence" of shocks to volatility. In the above respects, it is an improvement over the widely-used GARCH model. The model is applied to study volatility changes and the risk premium on the CRSP Value-Weighted Market Index from 1962 to 1987. Copyright 1991 by The Econometric Society.

10,019 citations


Additional excerpts

  • ...In addition, results available from the author show that price–dividend ratios have the ability to predict excess returns on equities, just as in the data (Campbell and Shiller, 1988; Fama and French, 1989), and that declines in the price–dividend ratio predict higher volatility (Black, 1976; Schwert, 1989; Nelson, 1991)....

    [...]

  • ...…from the author show that price–dividend ratios have the ability to predict excess returns on equities, just as in the data (Campbell and Shiller, 1988; Fama and French, 1989), and that declines in the price–dividend ratio predict higher volatility (Black, 1976; Schwert, 1989; Nelson, 1991)....

    [...]

Journal ArticleDOI
TL;DR: In this paper, the authors use an intertemporal general equilibrium asset pricing model to study the term structure of interest rates and find that anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices.
Abstract: This paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. In this model, anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices. Many of the factors traditionally mentioned as influencing the term structure are thus included in a way which is fully consistent with maximizing behavior and rational expectations. The model leads to specific formulas for bond prices which are well suited for empirical testing. 1. INTRODUCTION THE TERM STRUCTURE of interest rates measures the relationship among the yields on default-free securities that differ only in their term to maturity. The determinants of this relationship have long been a topic of concern for economists. By offering a complete schedule of interest rates across time, the term structure embodies the market's anticipations of future events. An explanation of the term structure gives us a way to extract this information and to predict how changes in the underlying variables will affect the yield curve. In a world of certainty, equilibrium forward rates must coincide with future spot rates, but when uncertainty about future rates is introduced the analysis becomes much more complex. By and large, previous theories of the term structure have taken the certainty model as their starting point and have proceeded by examining stochastic generalizations of the certainty equilibrium relationships. The literature in the area is voluminous, and a comprehensive survey would warrant a paper in itself. It is common, however, to identify much of the previous work in the area as belonging to one of four strands of thought. First, there are various versions of the expectations hypothesis. These place predominant emphasis on the expected values of future spot rates or holdingperiod returns. In its simplest form, the expectations hypothesis postulates that bonds are priced so that the implied forward rates are equal to the expected spot rates. Generally, this approach is characterized by the following propositions: (a) the return on holding a long-term bond to maturity is equal to the expected return on repeated investment in a series of the short-term bonds, or (b) the expected rate of return over the next holding period is the same for bonds of all maturities. The liquidity preference hypothesis, advanced by Hicks [16], concurs with the importance of expected future spot rates, but places more weight on the effects of the risk preferences of market participants. It asserts that risk aversion will cause forward rates to be systematically greater than expected spot rates, usually

7,014 citations

Journal ArticleDOI
TL;DR: This paper showed that an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.

6,141 citations


"A Consumption-Based Model of the Te..." refers methods in this paper

  • ...Thus, the model can fit the equity premium puzzle of Mehra and Prescott (1985)....

    [...]

Journal ArticleDOI
TL;DR: For example, this paper found that expected returns on common stocks and long-term bonds contain a term or maturity premium that has a clear business-cycle pattern (low near peaks, high near troughs).

4,110 citations


Additional excerpts

  • ...In addition, results available from the author show that price–dividend ratios have the ability to predict excess returns on equities, just as in the data (Campbell and Shiller, 1988; Fama and French, 1989), and that declines in the price–dividend ratio predict higher volatility (Black, 1976; Schwert, 1989; Nelson, 1991)....

    [...]

  • ...…from the author show that price–dividend ratios have the ability to predict excess returns on equities, just as in the data (Campbell and Shiller, 1988; Fama and French, 1989), and that declines in the price–dividend ratio predict higher volatility (Black, 1976; Schwert, 1989; Nelson, 1991)....

    [...]

Posted Content
TL;DR: In this paper, a consumption-based model is proposed to explain a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long-term horizon predictability of excess stock returns, and the countercyclical variations of stock market volatility.
Abstract: We present a consumption†based model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long†horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much of the history of stock prices from consumption data. It explains the short†and long†run equity premium puzzles despite a low and constant risk†free rate. The results are essentially the same whether we model stocks as a claim to the consumption stream or as a claim to volatile dividends poorly corelated with consumption. The model is driven by an independently and identically distributed consumption growth process and adds a slow †moving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia. Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of long†run average consumption growth.

3,886 citations

Frequently Asked Questions (1)
Q1. What are the contributions in "A consumption-based model of the term structure of interest rates" ?

This paper proposes a consumption-based model that can account for many features of the nominal term structure of interest rates.