Measuring time-varying economic fears with consumption-based stochastic discount factors

Belén Nieto and Gonzalo Rubio

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: This paper analyzes empirically the volatility of consumption-based stochastic discount factors as a measure of implicit economic fears by studying its relationship with future economic and stock market cycles. Time-varying economic fears seem to be well captured by the volatility of stochastic discount factors. In particular, the volatility of recursive utility-based stochastic discount factor with contemporaneous growth explains between 9 and 34 percent of future changes in industrial production at short and long horizons respectively. They also explain ex-ante uncertainty and risk aversion. However, future stock market cycles are better explained by a similar stochastic discount factor with long-run consumption growth. This specification of the stochastic discount factor presents higher volatility and lower pricing errors than the specification with contemporaneous consumption growth.

Keywords: Stochastic discount factor; economic fears; distance between probability measures; volatility of stochastic discount factor; consumption (search for similar items in EconPapers)
JEL-codes: E44 G10 G12 (search for similar items in EconPapers)
Date: 2007-04, Revised 2007-09
New Economics Papers: this item is included in nep-mac and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:upf:upfgen:1029

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