DP14588 Valuation Risk Revalued
This paper shows the success of valuation risk—time-preference shocks in Epstein-Zin
utility—in resolving asset pricing puzzles rests sensitively on the way it is introduced. The
specification used in the literature violates several desirable properties of recursive preferences
because the weights in the Epstein-Zin time-aggregator do not sum to one. When we revise the
specification in a simple asset pricing model the puzzles resurface. However, when estimating
a sequence of increasingly rich models, we find valuation risk under the revised specification
consistently improves the ability of the models to match asset price and cash-flow dynamics.