Date of Original Version
5-10-2009
Type
Working Paper
Abstract or Table of Contents
Empirically, the conditional volatility of aggregate consumption growth varies over time. While many papers test the consumption CAPM based on realized consumption growth, little is known about how the time-variation of consumption growth volatility aff ects asset prices. We show that in a model where (i) the agent has recursive preferences, (ii) the conditional first and second moments of consumption growth follow a Markov chain and (iii) the state of the economy is latent, the perception about conditional moments of consumption growth a ffect excess returns. In the data, we fi nd that the perceived consumption volatility is a priced source of risk and exposure to it strongly negatively predicts future returns in the cross-section. These results suggest that the representative agent has an elasticity of intertemporal substitution greater than unity. In the time-series, changes in beliefs about the volatility state strongly forecast aggregate quarterly excess returns.