Asset Returns and Economic Fluctuations

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At a general level, it is natural to expect that risks and rewards in the economy's production processes should vary over the course of economic fluctuations, and that asset returns should mirror this variation. However, the mechanism by which asset returns are linked to economic fluctuations is not yet well understood. The contribution of this project comes from developing empirically successful economic models of the links between asset returns and economic fluctuations. Such models are important because: 1) they will help discriminate between competing theories of business cycles; 2) they are one of the only ways of rigorously determining whether or not volatility in financial markets indicate speculative fads or the response of efficient markets to changes in fundamentals; and 3) successful economic models could improve portfolio allocation rules. The first part of this project extends a production-based asset pricing model, that is a model of the physical rates of return of production processes in the economy. The extension covers empirical tests of simultaneous variations in the returns on many different assets using several different techniques and cross- sectional data of asset prices; improvements in the description of technology; and the explicit study of time aggregation. The second part of the project involves the calculation of the variation in conditional moments of discount factors implied by variation in the conditional moments of asset returns. The results are used to determine whether or not the behavior of asset returns is due to "fads" or to rational movements in discount factors.