"Long-Run Risk through Consumption Smoothing"
©
The Review of Finanical Studies,
2010
Volume: 23
|
Issue: 8
|
Pages: 3141-3189
Publication type: Journal article
Research Archive Topic: Media and Technology, Risk Management
Abstract
We examine how long-run consumption risk arises endogenously in a standard production economy model where the representative agent has Epstein-Zin preferences. Even when technology growth is i.i.d., optimal consumption smoothing induces highly persistent time-variation in expected consumption growth (long-run risk). This increases the price of risk when investors prefer early resolution of uncertainty, and the model can then account for the low volatility of consumption growth and the high price of risk with a low coefficient of relative risk aversion. The asset price implications of endogenous long-run risk depends crucially on the persistence of technology shocks and investors preference for the timing of resolution of uncertainty.
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