Recursive preferences, consumption smoothing and risk premium

Abstract

This paper combines recursive preferences and the consumer ´s budget constraint to derive a relationship where the importance of the long-run risks can help explaining asset returns. Using data for sixteen OECD countries, we find that when the consumption growth, the consumption wealth ratio and its first-differences are used as conditioning information, the resulting factor model explains a large fraction of the variation in real stock returns. The model captures: (i) the preference of investors for a smooth consumption path as implied by the intertemporal budget constraint; and (ii) the large equity risk premium that agents demand when they fear a reduction in long-run economic prospects.