Asset Pricing Based on Micro Consumption

Abstract

This paper proposes an estimable asset pricing model that builds upon micro consumption and reference-dependent preference. Central to the model is an S-shaped consumption utility function that is convex below the reference point. The model quantitatively accounts for both low risk-free rates and high equity premiums. The S-shaped consumption utility works by rationalizing the micro-level finding that, for many people, consumption growth correlates negatively with asset returns. When global concavity is maintained, the equity premium puzzle remains because the estimated degree of relative risk aversion given a high consumption-reference ratio is absurdly large.