Date of Original Version



Working Paper

Rights Management

All Rights Reserved

Abstract or Description

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 affects 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 affect excess returns. In the data, we find 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.