RFS Advance Access published online on June 30, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp045
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Expected Returns and the Business Cycle: Heterogeneous Goods and Time-Varying Risk Aversion
Columbia University and London Business School
Send correspondence to Lars A. Lochstoer, Columbia University, Uris Hall 405B, 3022 Broadway, New York, NY 10027; telephone: 212-851-2119; fax: 212-316-9180. E-mail: LL2609{at}columbia.edu
JEL Classification: E2, G1
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Abstract |
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This paper proposes a representative agent habit-formation model where preferences are defined for both luxury goods and basic goods. The model matches the equity risk premium, risk-free rate, and volatilities. From the intratemporal first-order condition, one can substitute out basic good consumption and the habit level, yielding a stochastic discount factor driven by two observable risk factors: luxury good consumption and the relative price of the two goods. I estimate these processes and find them to be heteroskedastic, implying time variation in the conditional volatility of the stochastic discount factor. These dynamics occur both at the business cycle frequency and at a lower, "generational" frequency. The findings reveal that the time variation in aggregate stock market and Treasury bond risk premiums are consistent with the predictions of the model.
This paper is a substantially revised version of Chapter 1 of my dissertation at the Haas School of Business, University of California at Berkeley. I thank Pierre Collin-Dufresne, Roger Craine, Tom Davidoff, Francisco Gomes, Keener Hughen, Georg Kaltenbrunner, Shimon Kogan, Jacob Sagi, Richard Stanton, Motohiro Yogo, and especially my adviser Greg Duffee and an anonymous referee for helpful comments. I thank seminar participants at Amsterdam University, Berkeley, Boston College, Carnegie-Mellon, CEPR Gerzensee 2005, Columbia, London Business School, Norwegian School of Economics, Oslo School of Management (BI), Stanford, University of British Columbia, University of Southern California, University of Washington at Seattle, and the WFA 2005. I thank the Dean Witter Foundation and Senter for Pengepolitisk og Finansiell Forskning for financial support. All errors are mine alone.