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

Bansal, Ravi, and Amir Yaron, “Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles,” The Journal of Finance Vol. 59 (2004), 1481-1509.

Like Barro (2006), Bansal & Yaron try to resolve the Mehra-Prescott (1985) equity premium puzzle by adding more risk.  Whereas Barro’s risk is the small probability of a major economic disaster, Bansal and Yaron’s risk is a permanent component in the consumption growth process.

With a permanent component, a negative shock at any point in time to consumption should have effects reaching far into the future.  The shocks compound over time, in a sense.  This means consumers/investors should be very sensitive to news about consumption growth.

The authors decline to give economic rationale for why consumption growth should have a permanent component.  They say in the same breath that it is econometrically impossible to distinguish between iid consumption growth and a growth process with a permanent component, and that their model is consistent with observed data.  It follows that the opposite story (iid growth) is also consistent with the data!

Bansal and Yaron also equate consumption to expenditures, thus ignoring both savings and durable goods, both of which I believe have important implications for consumer behavior and asset pricing.