Paper #1029

Title:

Measuring time-varying economic fears with consumption-based stochastic discount factors

Authors:

Belén Nieto and Gonzalo Rubio

Date:

April 2007 (Revised: September 2007)

Abstract:

This paper analyzes empirically the volatility of consumption-based stochastic discount factors as a measure of implicit economic fears by studying its relationship with future economic and stock market cycles. Time-varying economic fears seem to be well captured by the volatility of stochastic discount factors. In particular, the volatility of recursive utility-based stochastic discount factor with contemporaneous growth explains between 9 and 34 percent of future changes in industrial production at short and long horizons respectively. They also explain ex-ante uncertainty and risk aversion. However, future stock market cycles are better explained by a similar stochastic discount factor with long-run consumption growth. This specification of the stochastic discount factor presents higher volatility and lower pricing errors than the specification with contemporaneous consumption growth.

Keywords:

Stochastic discount factor, economic fears, distance between probability measures, volatility of stochastic discount factor, consumption

JEL codes:

G10, G12, E44

Area of Research:

Finance and Accounting

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