Consumption-based Asset Pricing Model Research Articles

Nonsubstitutable Consumption Growth Risk

Standard applications of the consumption-based asset pricing model assume that goods and services within the nondurable consumption bundle are substitutes. We estimate substitution elasticities between different consumption bundles and show that households cannot substitute energy consumption by consumption of other nondurables. As a consequence, energy consumption affects the pricing function as a separate factor. Variation in energy consumption betas explains a large part of the premia related to value, investment, and operating profitability. For example, value stocks are typically more energy intensive than growth stocks and thus riskier, because they suffer more from the oil supply shocks that also affect households. This paper was accepted by Lukas Schmid, finance. Funding: C. Schlag gratefully acknowledges research and financial support from the Leibniz Institute for Financial Research SAFE. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2022.01269 .

On the sources of the aggregate risk premium: Risk aversion, bubbles or regime-switching?

We develop and estimate a consumption-based asset pricing model that uses historical US financial data and assumes recursive utility, allowing for priced regime-switching risk and intrinsic bubbles. We also estimate several restricted versions, including only a subset of these features. Priced regime-switching risk is essential to the equity risk premium, explaining more than fifty per cent of it. Furthermore, a model that does not consider regime switching would overestimate the public's risk aversion, mistakenly assigning the observed risk premium to high-risk aversion instead of priced regime-switching. We also find that intrinsic bubbles are statistically significant, and even though they are not crucial in explaining the risk premium, they substantially improve the model's fit at the end of the sample.

A consumption-based term structure model of bonds and equity

In this study, I propose a consumption-based asset pricing model to capture the dynamic properties of term structures of bonds and equity. I extend the long-run risks model by introducing a mean-reversion of dividend growth and the external habit formation of a representative agent. The mean-reverting dividend growth generates a negative equity term premium, while the habit formation augments the equity premium and renders an upward-sloping bond yield curve, on average. In addition, fluctuations in the surplus consumption ratio and the conditional variance of consumption growth allow the model to reproduce pro-cyclical variations in bond and equity yield spreads and counter-cyclical variations in bond and equity term premiums, as observed in the U.S. data.

Asset pricing and the carbon beta of externalities

Climate policy needs to set incentives for investors who face imperfect, distorted markets and large uncertainties about the costs and benefits of abatement. These investors decide on uncertain investments according to their expected return and risk (carbon beta). We study carbon pricing and financial incentives in a consumption-based asset pricing model distorted by technology spillovers and time-inconsistency. We find that both distortions reduce the equilibrium asset return and delay investment in abatement. However, their effect on the carbon beta and the risk premium for abatement can be decreasing (when innovation spillovers are not anticipated) or increasing (when climate policy is not credible). We show that the distortions can be overcome by modified carbon pricing by a regulator, or by financial incentives, implemented in our model by a long-term investment fund. The fund pays a subsidy to reduce technology costs or offers financial contracts to boost investment returns to complement the carbon price. The investment fund can thus pave the way for carbon pricing in later periods by preventing a capital misallocation that would be too expensive to correct, thus improving the feasibility of ambitious carbon pricing.

Do Consumption-Based Asset Pricing Models Explain the Dynamics of Stock Market Returns?

We show that three prominent consumption-based asset pricing models—the Bansal–Yaron, Campbell–Cochrane and Cecchetti–Lam–Mark models—cannot explain the dynamic properties of stock market returns. We show this by estimating these models with GMM, deriving ex-ante expected returns from them and then testing whether the difference between realised and expected returns is a martingale difference sequence, which it is not. Mincer–Zarnowitz regressions show that the models’ out-of-sample expected returns are systematically biased. Furthermore, semi-parametric tests of whether the models’ state variables are consistent with the degree of own-history predictability in stock returns suggest that only the Campbell–Cochrane habit variable may be able to explain return predictability, although the evidence on this is mixed.

Bank credit, consumption risk, and the cross-section of expected returns

Although the consumption capital asset pricing model has an unmatched theoretical purity for assets’ risk, the empirical failure of the model stands as a central finding in asset pricing. In an effort to resuscitate consumption-based asset pricing model, we develop and estimate new conditional consumption capital asset pricing models with bank credit growth and bank credit cycle as conditioning variables. Rather than assuming the constant factor loadings of asset returns on consumption growth, we model time-varying consumption beta as a function of bank credit growth or bank credit cycle. We find that our specifications explain satisfactorily the variation in stock returns across the 25 Fama–French portfolios. Moreover, the strict statistical tests on risk price and explanatory power show that the models compare favorably with other renowned asset pricing models. These findings document that the dispersion of expected returns is the outcome of the degree of reward for consumption risk, thereby being consistent with asset pricing theory.

International asset pricing with heterogeneous agents: Estimation and inference

This paper empirically validates (Constantinides and Ghosh’s, 2017) heterogeneous-agents consumption-based asset pricing model for predicting expected returns in international equity markets. Using the model’s implications, we proxy the unobservable state variable driving income shocks with the principal component of consumption growth cumulants across agents. We confirm that both the level and changes in this cross-sectional consumption risk serve as pricing factors, emphasizing the importance of higher moments like skewness. The estimated structural parameters obtained from the Euler equations are statistically significant and plausible, while the factor risk premium estimates align with theoretical expectations. Our approach effectively explains the emerging versus developed premium, outperforming traditional methods reliant on cross-sectional variance. Our findings, robust across different model specifications and asset menus, highlight the imprecision of consumption-based factor risk premia estimates when limited to developed markets, a limitation mitigated by including emerging markets. The model demonstrates a 60% explanatory power, surpassing the global Fama–French model.

Output gap and consumption risk on the cross-section of stock returns in Korea

We examine if output gap can be the conditioning information for consumption-based asset pricing model in the Korean stock market. In an effort to empirically explain the cross-sectional variation of stock returns with economic equilibrium model, our conditioning variable, output gap, enables consumption capital asset pricing model (CCAPM) to explain a substantial variation in the cross-section of stock returns in Korea. In addition, the conditional version of CCAPM with output gap as a conditioning variable can explain the cross-section of stock returns about as well as the Fama-French three- and five-factor model when using future consumption growth. Asset's riskiness is determined by the correlation with consumption growth conditional on the business cycle measured by the output gap. (JEL G12).

State intervention in land pricing and endogenous risk aversion

<p><big>This study explores the cause and effect of endogenous risk aversion in land pricing, where state intervention through taxation remains a general practice. Using a consumption-based asset pricing model incorporating taxation, it is shown that high taxation, due to the indexation effect, supporting land prices and reducing individuals' risk expectations, could lead to an endogenous decrease in risk aversion, which could result in market dysfunction because risk aversion plays a key role in the market mechanism. China, with its wholly state-owned land and the general use of land sales to cover financial deficits, is a typical case for empirical tests. The tests confirm that there, the rise in land prices was driven by the increase in reserve prices set by local governments, a strong means of taxation, and not by the market, indicating the endogenous decrease in risk aversion.</big></p>

Semiparametric estimation of latent variable asset pricing models

This paper studies semiparametric identification and estimation of consumption-based asset pricing models with latent state variables. First, we measure how consumption, dividends, and prices depend on Markovian state variables describing aggregate output growth. Subsequently, we identify state-dependent components in the stochastic discount factor using the Euler equation. We develop tractable algorithms for filtering, smoothing, and sieve maximum likelihood estimation, and establish its consistency. Empirically, we find sizable nonlinearities in the impact of expected growth and volatility on the price–dividend ratio and discount factor.

Extrapolative asset pricing

This paper studies implications of return extrapolation in a consumption-based asset pricing model. We show that return extrapolation has strong implications for the pricing kernel. The time variation in the agent's return expectations is mainly reflected in the short rate and little in return volatility and equity premium. Return extrapolation causes return volatility and equity premium to be lower than the rational counterparts. In addition to the risk premium, the equity premium can include a sentiment premium that is due to dividend expectation bias rather than return extrapolation bias. Thus, time-varying dividend (rather than return) expectation bias helps produce a volatile equity premium. These results show that return extrapolation exacerbates asset pricing puzzles and fundamental extrapolation helps resolve puzzles.

The Variance Risk Premium in Equilibrium Models

Abstract The equity variance risk premium is the expected compensation earned for selling variance risk in equity markets. The variance risk premium is positive and shows only moderate persistence. High variance risk premiums coincide with the left tail of the consumption growth distribution shifting down. These facts, together with risk-neutral skewness being substantially more negative than physical return skewness, refute the bulk of the extant consumption-based asset pricing models. We introduce a tractable habit model that does fit the data. In the model, the variance risk premium depends positively (or negatively) on “bad” (or “good”) consumption growth uncertainty.

Asset pricing with two types of heterogeneous consumption volatilities in mind: Evidence from China

Recent studies have highlighted asymmetric asset pricing in different economic states. We divide China's aggregate consumption into two specific sets and determine two heterogeneous consumption volatilities. One positively mirrors the state of good times, and the other positively maps the state of bad times. We then propose a consumption-based asset pricing model that is associated with economic times, in which two pricing factors related to the two consumption volatilities play antagonistic roles. Theoretical and empirical analyses based on the model indicate that equity premiums are low during good times but high during bad times. Specifically, equity premiums are more susceptible to bad times. Moreover, the model plausibly accounts for variations in cross-sectional patterns and outperforms three- and five-factor models (Fama and French, 1993, 2015) at the stock portfolio level owing to its relatively minimal pricing error.

Understanding probabilistic expectations – a behavioral approach

I propose a simple heuristic to explain how people estimate the probability of an event that has binary outcomes, such as a boom vs. a recession. Central to this approach is a psychological trait called “base-rate neglect” — a tendency for people to ignore prior probabilities in favor of more salient diagnostic information. When making predictions, people’s decisions are experience-based, but are influenced by base-rate neglect. I construct an algorithm to replicate this behavior, and find that its predictions match key features of the Anxious Index in the Survey of Professional Forecasters and stock market expectations in the Surveys of Consumers. If investors use this heuristic to form expectations in a consumption-based asset pricing model, both the equity premium and its volatility will be higher than those in a rational expectations model.

Examining the sources of excess return predictability: Stochastic volatility or market inefficiency?

We use a consumption based asset pricing model to show that the predictability of excess returns on risky assets can arise from only two sources: (1) stochastic volatility of fundamental variables, or (2) departures from rational expectations that give rise to predictable investor forecast errors and market inefficiency. While controlling for stochastic volatility, we find that a variable which measures non-fundamental noise in the Treasury yield curve helps to predict 1-month-ahead excess stock returns, but only during sample periods that include the Great Recession. For these sample periods, higher noise predicts lower excess stock returns, implying that a shortage of arbitrage capital in financial markets allowed excess returns to drop below the levels justified by fundamentals. The statistical significance of the predictor variables that control for stochastic volatility are also typically sensitive to the sample period. Measures of implied and realized stock return variance cease to be signficant when the COVID-influenced data from early 2020 onward is included.

Examining the Sources of Excess Return Predictability: Stochastic Volatility or Market Inefficiency?

We use a consumption based asset pricing model to show that the predictability of excess returns on risky assets can arise from only two sources: (1) stochastic volatility of fundamental variables, or (2) departures from rational expectations that give rise to predictable investor forecast errors and market inefficiency. While controlling for stochastic volatility, we find that a variable which measures non-fundamental noise in the Treasury yield curve helps to predict 1-month-ahead excess stock returns, but only during sample periods that include the Great Recession. For these sample periods, higher noise predicts lower excess stock returns, implying that a shortage of arbitrage capital in financial markets caused excess returns to drop below the levels justified by fundamentals. The statistical significance of the predictor variables that control for stochastic volatility are also typically sensitive to the sample period. Measures of implied and realized stock return variance cease to be significant when the COVID-influenced data from early 2020 onward is included.

Pairs trading and asset pricing

Existing work on pairs trading do not detail how the variables selected explain the cross section of stock returns. We evaluate whether these variables contribute to the dynamics of the equity risk premium for a broadly diversified portfolio of Chinese stocks. Based on pairs trading strategy, several arbitrage-related factors are proposed. In an equilibrium exchange economy, where the idiosyncratic component of the stock return is modeled as per the Ornstein-Uhlenbeck process, the equity risk premium is obtained from a consumption-based asset pricing model. Sorting individual stocks into portfolios based on a single factor, a long-short strategy is formed by buying and selling stocks in the highest and lowest quintiles, respectively. The differences in the subsequent extreme portfolio return are economically large and highly statistically significant. These differences remain significant after controlling for other documented firm characteristics and explanatory variables in the Fama-Macbeth regressions and double sorting.

Price and Payoff Autocorrelations in a Multi-period Consumption-Based Asset Pricing Model

This paper considers common consumption-based asset pricing model and derives approximations of the basic pricing equation that describes mutual dependence of the mean price "to-day", mean payoff "next-day", price and payoff volatility and impact of the price and payoff autocorrelations. The deep conjunction of the consumption-based model with other modifications of asset pricing as ICAPM, APM and etc. (Cochrane, 2001) causes that our results can be derived in other versions of CAPM. We introduce the market-based price averaging and discuss the origin of its distinctions from the common frequency-based price probability. The market-based price statistical moments, price volatility and autocorrelation are determined by statistical moments of the random market trade value and volume. Distinctions between the frequency-based and the market-based approaches to price averaging cause different assessment of the price volatility and autocorrelation and result in different treatment of the price-volume relations in particular. The market-based price averaging provides direct dependence of the price statistical moments on the market trade value and volume statistical moments. It establishes a unified ground for description of financial markets but uncovers tough complexity. The usage of the frequency-based or proposed market-based price averaging is completely determined by agent's preferences, beliefs and habits. The collision between 'rational' market-based approach and "soulful" or "home-felt" frequency-based approach to price averaging creates significant challenge for financial theory.

Um Tutorial sobre o Método Generalizado dos Momentos (GMM) em Finanças

ABSTRACT Context: empirical problems in which the researcher is faced with a model that is partially specified. In these cases, the GMM method is the natural alternative for estimating the parameters of interest. Objective: the goal of this paper is to offer a tutorial that allows the researcher to understand both the theory and empirical aspects of the GMM method. Methods: we discuss the GMM concepts, forms of estimation, and limitations associated with the method. As a way of illustrating the method, we use two applications in the area of empirical finance. The first application is the estimation of the parameters of a consumption-based asset pricing models; the second is the estimation of the parameters of the evolution of the interest rate in continuous time. The data and codes in R are provided as online appendices. Conclusion: the GMM method can be used in problems where other methods such as maximum likelihood are not feasible, or even when the researcher wants to estimate a model partially specified.

Liquidity risk, transaction costs and financial closedness: lessons from the Iranian and Turkish stock markets

PurposeThis paper aims to study the impact of liquidity risk and transaction costs on stock pricing in Iran, a closed market operating under a financial embargo and compare the results with those of an important neighboring market, namely, Turkey.Design/methodology/approachThis study follows Liu et al. (2016) and incorporates liquidity risk and transaction costs into the traditional consumption-based asset-pricing model (CCAPM) from 2009 to 2017. Effective transaction costs are estimated a la Hasbrouck (2009) and liquidity risk according to eight different criteria.FindingsAccording to the results, both liquidity risk and transaction costs are higher in Iran, possibly due to the financial embargo. Thus, relative to Turkey, this paper should expect a higher increase in the CCAPM pricing performance in Iran when accounting for these two variables. The results are in line with this expectation and indicate that adjusting the CCAPM significantly increases its pricing performance in both countries, but relatively more in Iran.Originality/valueThis study compares liquidity risk and transaction costs in an economy under the extreme case of a financial embargo to an open yet in other important aspects similar economy from the same region.