infonet-economy

Most standard asset-pricing models assume that all shocks to consumption are permanent. We relax this assumption and allow also for temporary shocks. The implications of our model are dramatically different from those obtained in the prior literature. A canonical and parsimonious asset pricing model with CRRA preferences and temporary shocks can reproduce the equity premium, high return volatility and return predictability with a coefficient of relative risk aversion below ten. This finding suggests that temporary shocks can play an important role in explaining asset pricing puzzles