The authors model consumption and dividend growth rates as containing both a small long-run predictable component and fluctuating economic uncertainty (consumption volatility). These dynamics, for which they provide empirical support, in conjunction with generalized recursive preferences, can explain key asset markets phenomena. The model can justify the equity premium, the risk-free rate, and the volatility of the market return, risk-free rate, and the price-dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time-varying.
Dynamic Portfolio Choice
The authors present a novel approach to dynamic portfolio selection that is as easy to implement as the static Markowitz paradigm. They expand the set of assets to include mechanically managed portfolios and optimize statically in this extended asset space. They consider “conditional” portfolios, which invest in each asset an amount proportional to conditioning variables, and “timing” portfolios, which invest in each asset for a single period and in the risk-free asset for all other periods. The static choice of these managed portfolios represents a dynamic strategy that closely approximates the optimal dynamic strategy for horizons up to five years.
Term Structure of Interest Rates
The authors develop a term structure model where the short interest rate and the market price of risks are subject to discrete regime shifts. Empirical evidence from Efficient Method of Moments estimation provides considerable support for the regime shifts model. Standard models, which include affine specifications with up to three factors, are sharply rejected in the data. Their diagnostics show that only the regime shifts model can account for the well-documented violations of the expectations hypothesis, the observed conditional volatility, and the conditional correlation across yields. They find that regimes are intimately related to business cycles.