Cointegration and Consumption Risks in Asset Returns

• Published in: The Review of financial studies Vol. 22; no. 3; pp. 1343 - 1375
• Main Authors: Bansal, Ravi, Dittmar, Robert, Kiku, Dana
• Format: Journal Article
• Language: English
• Published: Oxford Oxford University Press 01-03-2009; Oxford Publishing Limited (England)
• Subjects: Aggregate analysis; Assets; Cointegration; Cointegration analysis; Consumption; Covariance; Dividends; Empirical evidence; Equity; Error correction & detection; Expected returns; Financial portfolios; Informational error correction; Investment horizon; Investment risk; Investments; Macroeconomics; Rates of return; Regression analysis; Risk premiums; Stock returns; Studies; Vector autoregression; Vector-autoregressive models; G12; G1
• ISSN: 0893-9454; 1465-7368
• DOI: 10.1093/rfs/hhm085

We argue that the cointegrating relation between dividends and consumption, a measure of long-run consumption risks, is a key determinant of risk premia at all investment horizons. As the investment horizon increases, transitory risks disappear, and the asset's beta is dominated by long-run consumption risks. We show that the return betas, derived from the cointegration-based VAR (EC-VAR) model, successfully account for the cross-sectional variation in equity returns at both short and long horizons; however, this is not the case when the cointegrating restriction is ignored. Our evidence highlights the importance of cointegration-based long-run consumption risks for financial markets.