Business - cycle consumption risk and asset prices ∗

We disaggregate consumption growth into components with different levels of persistence and show that a single business-cycle consumption factor can explain satisfactorily the differences in risk premia across book-to-market and size-sorted portfolios. We argue that accounting for persistence heterogeneity in consumption is important for interpreting cross-sectional risk compensations in financial markets but also for capturing the joint time-series dynamics of consumption and returns across horizons (for instance, the hump-shaped pricing ability of the covariance between “ultimate consumption” and returns, the hump-shaped structure of long-run risk premia as well as the decaying pattern in consumption growth predictability). Using a novel time/frequency-based data generating process for consumption growth and asset returns, we discuss implications for the asset pricing literature relying on aggregation. JEL classification: C22, C32, E32, E44, G12