Risk and return on bond, currency and equity markets: A unified approach. Working paper

George Tauchen, Adrien Verdelhan for their helpful comments and suggestions. The usual disclaimer applies. Risk and Return in Bond, Currency and Equity Markets We develop a general equilibrium long-run risks model that can simultane-ously account for key asset price puzzles in bond, currency and equity markets. Specifically, we show that the model can explain the predictability of returns and violations of the expectations hypothesis in bond and foreign exchange markets. It also accounts for the levels and volatilities of bond yields and exchange rates, and the well-known risk premium and volatility puzzles in equity markets. The model matches the observed consumption and inflation dynamics. Using domestic and foreign consumption and asset markets data we provide robust empirical support for our models predictions. We argue that key economic channels featured in the long-run risks model — long-run growth fluctuations and time-varying uncertainty, along with a preference for early resolution of uncertainty — provide a coherent framework to simultaneously explain a rich array of asset market puzzles.