Working Paper: NBER ID: w11476
Authors: Lars Peter Hansen; John Heaton; Nan Li
Abstract: We characterize and measure a long-run risk return tradeoff for the valuation of financial cash flows that are exposed to fluctuations in macroeconomic growth. This tradeoff features components of financial cash flows that are only realized far into the future but are still reflected in current asset values. We use the recursive utility model with empirical inputs from vector autoregressions to quantify this relationship; and we study the long-run risk differences in aggregate securities and in portfolios constructed based on the ratio of book equity to market equity. Finally, we explore the resulting measurement challenges and the implied sensitivity to alternative specifications of stochastic growth.
Keywords: Long-run risk; Asset pricing; Stochastic growth; Consumption
JEL Codes: G1; E2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| long-run risk (G19) | valuation of financial cash flows (G19) |
| stochastic growth processes (C69) | long-run risk (G19) |
| long-run cash flow variability (D25) | risk adjustments (G22) |
| cash flow growth rates (D25) | risk adjustments (G22) |
| expected growth rates (O40) | long-run risk-return tradeoff (G11) |
| discounting of cash flows (H43) | long-run risk-return tradeoff (G11) |