DP8150 Asset Return Dynamics Under Bad Environment-Good Environment Fundamentals

Author(s):	Geert Bekaert, Eric Engstrom
Publication Date:	December 2010
Keyword(s):	countercyclical risk aversion, dividend yield, economic uncertainty, equity premium, return predictability, variance premium
JEL(s):	e44, g12, g15
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=8150

We introduce a "bad environment-good environment" technology for consumption growth in a consumption-based asset pricing model. Using the preference structure from Campbell and Cochrane (1999), the model generates realistic time-varying volatility, skewness and kurtosis in fundamentals while still permitting closed-form solutions for asset prices. The model not only fits standard salient asset prices features including means and volatilities for equity returns and risk free rates, but also generates a realistic variance premium and option prices.