Consumption-based asset pricing models (theory)

Abstract

The essential element in modern asset pricing theory is a positive random variable called ‘the stochastic discount factor’ (SDF). This object allows one to price any payoff stream. Its existence is implied by the absence of arbitrage opportunities. Consumption-based asset pricing models link the SDF to the marginal utility growth of investors – and in turn to observable economic variables – and in doing so they provide empirical content to asset pricing theory. This article discusses this class of models.KeywordsConsumption-based asset pricing modelsEquity premium puzzleEuler equationsSharpe ratioStochastic discount factorJEL ClassificationsD4D10G12