Asset Return Dynamics under Bad Environment-Good Environment Fundamentals

We introduce a “bad environment-good environment” technology for consumption growth in a consumption-based asset pricing model. Using the preference structure from Campbell and Cochrane (1999), the model generates realistic time-varying volatility, skewness and kurtosis in fundamentals while still permitting closed-form solutions for asset prices. The model not only fits standard salient asset prices features including means and volatilities for equity returns and risk free rates, but also generates a realistic variance premium and option prices. ∗Columbia Business School, 802 Uris Hall, 3022 Broadway, New York New York, 10027; ph: (212)-854-9156; fx: (212)-662-8474; [email protected]. †Board of Governors of the Federal Reserve System, Washington, DC, 20551, ph: (202)-452-3044; fx: (202)-7285887; [email protected]. The authors especially thank Stephen Figlewski for providing time series data on the risk neutral density of returns. The views expressed in this article do not necessarily represent those of the Federal Reserve System or its staff.