Durable Consumption, Long-Run Risk and The Equity Premium

Na Guo and Peter Smith

Discussion Papers from Department of Economics, University of York

Abstract: This paper develops the CCAPM model to allow for long-run risk in durable consumption. Allowing Epstein-Zin preferences to incorporate non-separability of durable and non-durable consumption in utility provides for an Euler equation which can be shown to provide a much better explanation of equity market features than either the basic CAPM or CCAPM. .The paper incorporates this discount factor into a model with long-run durable consumption risk and provides the first set of estimates of such a model. The analysis in the paper is for the UK. This is of independent interest. There is thus far no evidence for the UK on the abilities of either the durable consumption or long-run risk models. Moreover, the nature of the time series process that best explains non-durable consumption growth in the UK suggests that the standard non-durable long-run risk model is unlikely to fit the facts. In short, there is no evidence for the presence of a persistent, heteroskedastic component in non-durable consumption growth. However, there is some quite persuasive evidence that such a component exists in durable consumption growth. This paper provides positive evidence in respect of the equity premium, matching the risk-free rate and ability to explain the cross-section of equity returns

Keywords: Equity Returns; Risk Premium; Durable Consumption Goods (search for similar items in EconPapers)
JEL-codes: C32 C51 E44 G12 (search for similar items in EconPapers)
Date: 2012-12
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