A New Perspective on the Price & Amount of Consumption Risk : Implications on Asset Dynamics

We propose a model where heterogeneous investors endogenously enter or exit the stock market. We characterize the equilibrium and present a novel conditional consumption-CAPM. The model implies a mild procyclical market entry and countercyclical exit. This small change in the composition of stockholders implies a strongly countercyclical stockholders' amount of consumption risk while maintaining a procyclical aggregate consumption risk. The price of consumption risk dynamics is affected by two counterbalancing effects: consumption re-distribution and market entry/exit. We find that the latter effect dominates the former, leading to a procyclical price of consumption risk. Overall, our model provides a new perspective on the main drivers of asset dynamics. It is the procyclical consumption risk-sharing implied by changes in stockholders' composition that contributes to the dynamics of risk premium, excess volatility, and price-dividend ratio. We provide empirical evidence on market participation, amount of risk, and price of risk supporting our theory