DP9262 Valuation Risk and Asset Pricing

Author(s): Rui Albuquerque, Martin Eichenbaum, Sérgio Rebelo
Publication Date: December 2012
Keyword(s): bond yields, Equity premium, risk premium
JEL(s): G12
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9262

Standard representative-agent models have difficulty in accounting for the weak correlation between stock returns and measurable fundamentals, such as consumption and output growth. This failing underlies virtually all modern asset-pricing puzzles. The correlation puzzle arises because these models load all uncertainty onto the supply side of the economy. We propose a simple theory of asset pricing in which demand shocks play a central role. These shocks give rise to valuation risk that allows the model to account for key asset pricing moments, such as the equity premium, the bond term premium, and the weak correlation between stock returns and fundamentals.