Robust test of Long Run Risk and Valuation risk model
Working Papers from Dipartimento Scienze Economiche, Universita' di Bologna
This paper tests the long run risk and valuation risk model using a robust estimation procedure. The persistent long run component of consumption growth process is proxied by a news based index that is created using a random forest algorithm. This news index is shown to predict aggregate long term consumption growth with an R-square of 57% and is robust to inclusion of other commonly used predictors. I theoretically derive an estimatable bias term in adjusted Euler equation of the model that arises due to measurement error in consumption data and show that this bias term is non-zero. Using a three pass estimation procedure that accounts for this bias, I show that the long run risk and valuation risk model fails to explain cross section of equity returns. This contrasts to the results from regular two pass Fama-MacBeth estimation procedure that implies that the same model explains the cross section of asset returns with statistically significant risk premia estimates.
JEL-codes: G12 E21 E44 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:bol:bodewp:wp1107
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