Asset Pricing with Heterogeneous Agents and Long-Run Risk

Abstract

This paper examines the effects of the heterogeneity of agents’ beliefs about the persistence of long-run risks in consumption-based asset-pricing models. Agents who believe in a lower persistence level dominate the economy rather quickly, even if their belief is wrong. In a standard calibration of the long-run risk model, this dominance drives the equity premium down below the level observed in the data. Simultaneously, belief heterogeneity can generate significant excess volatility and priced consumption risk due to changes in the wealth distribution. This effect in turn helps to explain several asset-pricing puzzles such as the large countercyclical variation of expected risk premia, the volatility of the price–dividend ratio, and the predictability of cash flows and returns. A new calibration of the heterogeneous-agents long-run risk model can simultaneously explain the large equity premium and the aforementioned puzzles.