Working Paper

Precautionary Volatility and Asset Prices

Abstract: Many theories of asset prices assume time-varying uncertainty in order to generate time-varying risk premia. This paper generates time-varying uncertainty endogenously, through precautionary saving dynamics. Precautionary motives prescribe that, in bad times, next period's consumption should be very sensitive to news. This time-varying sensitivity results in time-varying consumption volatility. Production makes this channel visible, and external habit preferences amplify it. An estimated model featuring this channel quantitatively accounts for excess return and dividend predictability regressions. It also matches the first two moments of excess equity returns, the risk-free rate, and the second moments of consumption, output, and investment.

Keywords: Time-varying risk premia; equity premium puzzle; time-varying volatility; habit; precautionary savings;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2014-08-12

Number: 2014-59

Pages: 63 pages