Long‐Run Risk and Its Implications for the Equity Premium Puzzle: New Evidence from a Multivariate Framework

This paper investigates the empirical evidence of long‐run risk and its implications for the equity premium puzzle. We find that the long‐run risk model is generally weakly identified and that standard inferences tend to underestimate the uncertainty of long‐run risk. We extend the LM‐type test of Ma and Nelson (2010) that remains valid under weak identification to the bivariate VARMA‐GARCH model of consumption and dividend growth. The results cast doubt on the validity of long‐run risk as an explanation for the equity premium puzzle. We also evaluate the approach of Bansal, Kiku, and Yaron (2007a), which extracts long‐run risk by regressing consumption growth and its volatility on predictive variables. The results using the Bonferroni Q‐test of Campbell and Yogo (2006) suggest that consumption and dividend growth are generally unpredictable by the price‐dividend ratio and risk‐free rate. This casts doubt on the validity of the BKY approach.