Essays on the role of long run risks in asset markets

• Main Author: Kiku, Dana
• Format: Dissertation
• Language: English
• Subjects: economics, finance
• ISBN: 9780549068228; 0549068228

This dissertation, consisting of three related essays, contributes to a recent literature that aims to understand the role of long-run consumption risks in asset markets. Specifically, my research highlights the importance of long-run properties of assets' cash flows in explaining the magnitude of the risk premium and its variation in the cross-section of assets. In addition, it analyzes the implications of long-run relation between firms' cash flows and aggregate consumption for optimal allocation decisions at different investment horizons.
The first chapter provides an explanation of the value premium puzzle, observed differences in price-dividend and Sharpe ratios of value and growth assets and variance-covariance structure of their realized returns within the long-run risks model of Bansal and Yaron (2004). The value premium in the model arises due to differential sensitivity of value and growth firms' cash flows to low-frequency consumption fluctuations, well-documented in the data. Furthermore, heterogeneity in systematic risks across firms helps account for the empirical failure of the standard CAPM and C-CAPM.
The second essay (co-authored with Ravi Bansal) argues that economic restrictions of cointegration between assets' cash flows and aggregate consumption have important conceptual and empirical implications for return dynamics and asset allocations at various investment horizons. We show that temporary deviations of cash flows from their long-run equilibrium relation with consumption forecast long-horizon dividend growth rates and returns. Consequently, the error-correction mechanism in cash flows significantly alters the risk-return tradeoff and so does the shape of optimal portfolio rules implied by models where the long-run dynamics of cash flows are ignored. We evaluate the impact of parameter uncertainty in the cointegration-based setup and show that the importance of the error-correction channel is fairly robust to estimation errors.
The third chapter analyzes the relative contribution of long- versus short-run risks in asset cash flows and returns to the overall risk premium. Using various identification schemes, I isolate permanent and transitory consumption shocks and show that the cost of long-run consumption uncertainty far exceeds that for transitory (business-cycle) fluctuations in consumption. This evidence reinforces findings in the recent asset pricing literature that long-run consumption risks are the dominant source of risk compensations in financial markets.