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Empirically, the conditional volatility of aggregate consumption growth varies over time. While many papers test the consumption CAPM based on realized consumption growth, little is known about how the time-variation of consumption growth volatility affects asset prices. The authors show that in a model where the agent has recursive preferences, the conditional first and second moments of consumption growth follow a Markov chain and the state of the economy is latent, the perception about conditional moments of consumption growth affect excess returns. In the data, they find that the perceived consumption volatility is a priced source of risk and exposure to it strongly negatively predicts future returns in the cross-section.
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