Long-run expected consumption and volatility risk, and the cross-section of asset returns

Abstract: This paper builds on the Long-Run Risks Framework in the quest of explaining the true nature of risk that drives asset prices. Instead of modeling expected consumption as in past research, we use the forward-looking Michigan Consumer Sentiment Index to proxy innovations in the agent's beliefs about expected consumption growth. We use monthly data from 1979.03-2011.12 in our cross-sectional tests using the Fama & Macbeth procedure on portfolios sorted on value and size, short-term reversal and size, as well as long-term reversal and size. In line with theory, our findings suggest that an assets that covaries positively with changes in beliefs about expected consumption growth requires a risk premia. Growth in economic uncertainty, defined as innovation in expected consumption volatility is negatively priced in our tests which confirm the general findings of the Long-Run Risks literature.