Macroeconomic Uncertainty and Asset Prices : A Stochastic Volatility Model

In this paper we measure the time-varying uncertainty of macroeconomic fluctuations and study its link to asset returns via a consumption-based asset pricing model. To this end, we introduce a stochastic volatility model employing a latent nonstationary common volatility with two asymptotic regimes and smooth transition between them. We define the common volatility factor extracted from consumption and dividend growth rates as the macroeconomic uncertainty and analyze its effects on asset prices using a model with the Epstein-Zin-Weil preferences. The presence of smooth transition in our volatility model creates another layer of uncertainty in macroeconomic fluctuations, and thus provides an additional channel that generates a sizable risk premium for even a small amount of the consumption volatility. The channel can play an important role in determining asset prices, especially if the perceived macroeconomic uncertainty unravels slowly. Our estimates for the risk aversion and elasticity of intertemporal substitution are both around two, and the simulation results show that the model matches the first and the second moments of market return and the risk-free rate, hence the equity premium