This paper analyzes the equilibrium effects of investment commitment on asset prices when the representative consumer has Epstein-Zin utility. Investment commitment captures the idea that long-term investment projects require not only current expenditures but also commitment to future expenditures. The general equilibrium effects of investment commitment and Epstein-Zin preferences generate endogenously time-varying first and second moments of consumption growth and stock returns. As a result, the first and second moments of excess returns are endogenously counter-cyclical, excess returns are predictable, and the equity premium increases by an order of magnitude. This paper also offers novel empirical findings regarding the predictability of returns. In the model, lagged investment arises as a state variable, determining the amount of committed expenditures. In the real and simulated data, the lagged investment rate helps to forecast the mean and volatility of returns.
Best Paper Award at the 2008 Frank Batten Young Scholars in Finance Conference