Consumption-based Asset Pricing Model Research Articles

On the Determination of General Scientific Models With Application to Asset Pricing

We consider a consumption-based asset pricing model that uses habit persistence to overcome the known statistical inadequacies of the classical consumption-based asset pricing model. We find that the habit model fits reasonably well and agrees with results reported in the literature if conditional heteroskedasticity is suppressed but that it does not fit nor do results agree if conditional heteroskedasticity, well known to be present in financial market data, is allowed to manifest itself. We also find that it is the preference parameters of the model that are most affected by the presence or absence of conditional heteroskedasticity, especially the risk aversion parameter. The habit model exhibits four characteristics that are often present in models developed from scientific considerations: (1) a likelihood is not available; (2) prior information is available; (3) a portion of the prior information is expressed in terms of functionals of the model that cannot be converted into an analytic prior on model parameters; (4) the model can be simulated. The underpinning of our approach is that, in addition, (5) a parametric statistical model for the data, determined without reference to the scientific model, is known. In general one can expect to be able to determine a model that satisfies (5) because very richly parameterized statistical models are easily accommodated. We develop a computationally intensive, generally applicable, Bayesian strategy for estimation and inference for scientific models that meet this description together with methods for assessing model adequacy. An important adjunct to the method is that a map from the parameters of the scientific model to functionals of the scientific and statistical models becomes available. This map is a powerful tool for understanding the properties of the scientific model.

Asset pricing with incomplete information and fat tails

We study a consumption-based asset pricing model with incomplete information and α-stable shocks. Incomplete information leads to a non-Gaussian filtering problem. Bayesian updating generates fluctuating confidence in the agents’ estimate of the persistent component of the dividends’ growth rate. This has the potential to generate time variation in the volatility of model-implied returns, without relying on discrete shifts in the drift rate of dividend growth rates. A test of the model using US consumption data shows that implied returns display significant volatility persistence of a magnitude comparable to that in the data.

Asset Pricing with Home Capital

I analyze a stylized consumption-based asset pricing model that features heterogeneous agents and household capital, and discover a novel recession risk factor related to the cross-sectional second moments of the corresponding investments into such home capital. In order to fully isolate the orthogonal effects at work, I completely shut off the well-known mechanism of Constantinides and Duffie (1996) by explicitly stipulating homoscedastic cross-sectional distribution of nondurable goods and services.

The Levered Equity Risk Premium and Credit Spreads: A Unified Framework

We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions.

Global Asset Pricing: Is There a Role for Long-Run Consumption Risk?

We estimate long-run consumption-based asset pricing models using a comprehensive set of international test assets, including broad equity market portfolios, international value/growth portfolios, and international bond portfolios. We find that differences in returns across assets within a country are sometimes (and most prominently for the U.S.) better captured by the assets' exposure to long-run consumption risk as opposed to their exposure to one-period changes in consumption (the canonical consumption CAPM). Across countries, however, exposure to long-run consumption risk does not provide a better fit than the canonical consumption CAPM. Thus, when characterizing the cross-country distribution of returns, long-run consumption risk does not seem to play any particular role, even if long-run risk is important for explaining the cross section of expected returns in the U.S. Furthermore, we show that consumption growth is more predictable over short to medium-run horizons than over longer horizons and that empirical evidence of a declining risk aversion parameter estimate in long-run risk models has to be interpreted with care.

The Aggregate Dynamics of Capital Structure and Macroeconomic Risk

We study the impact of time-varying macroeconomic conditions on optimal dynamic capital structure and the aggregate dynamics of firms in a cross-section. Our structural-equilibrium framework embeds a contingent-claim corporate financing model within a standard consumption-based asset-pricing model. This enables us to investigate the effect of macroeconomic conditions on asset valuation and optimal corporate policies as well as study the impact of preferences on capital structure. We find that capital structure is pro-cyclical at refinancing dates when firms relever, but counter-cyclical in aggregate dynamics, consistent with empirical evidence. Financially constrained firms follow more pro-cyclical policies. Capital structure is path-dependent. Leverage accounts for most of the macroeconomic risk relevant for predicting defaults. The paper also develops a number of novel empirically testable conjectures on capital structure in a dynamic economy.

Asset Prices Under Habit Formation and Reference-Dependent Preferences

This article explains the high level and the countercyclical variation of the equity premium in a consumption-based asset pricing model with low large-scale risk aversion. Investors have gain-loss utility over consumption relative to slowly time-varying habit. Stocks deliver low returns in recessions when consumption falls below habit; investors therefore require a high premium for holding stocks. The model's conditional moment restrictions are tested on consumption and asset returns data. The empirical estimate of large-scale risk aversion is low, whereas the estimate of loss aversion agrees with prior experimental evidence.

Consumption Risk and the Cross-Section of Government Bond Returns

We use a consumption-based asset pricing model with Epstein-Zin-Weil recursive preferences to explain the cross-section of excess returns on nominal US Treasury bond portfolios. We use a novel approach to extract the model factors from a FAVAR using a large panel; of macro and financial data. We find, over the period 1975-2006, that nominal government bonds are risky assets that pay off in good times characterized by good prospects for future consumption growth. Further, our model explains well the cross-sectional variation in average excess government bond returns, provides plausible estimates of the structural parameter and compares favourably with competing models. estimation methods.

Predictability in Consumption Growth and Equity Returns: A Bayesian Investigation

We estimate a widely cited consumption-based asset pricing model using fully Bayesian MCMC method. Although the model is generally consistent with consumption and dividend growth moments in annual data, the conditional mean of consumption growth (a latent process) is not persistent enough to satisfy the model's restriction that the price/dividend ratio be an affine function of the latent process. We argue that this lack of persistence in the latent process may result in equity volatility puzzle. The model accounts for only 50% of total variation in asset returns. The model can explain equity premium at a cost of high risk aversion. We also find that a one-factor nature of the model implies zero predictability of excess equity returns by price/dividend ratios.

Asset pricing with loss aversion

Abstract The use of standard preferences for asset pricing has not been very successful in matching asset price characteristics, such as the risk-free interest rate, equity premium and the Sharpe ratio, to time series data. Behavioral finance has recently proposed more realistic preferences such as those with loss aversion. Research is starting to explore the implications of behaviorally founded preferences for asset price characteristics. Encouraged by some studies of Benartzi and Thaler [1995. Myopic loss aversion and the equity premium puzzle. The Quarterly Journal of Economics 110 (1), 73–92] and Barberis et al. [2001. Prospect theory and asset prices. Quarterly Journal of Economics CXVI (1), 1–53] we study asset pricing with loss aversion in a production economy. Here, we employ a stochastic growth model and use a stochastic version of a dynamic programming method with an adaptive grid scheme to compute the above mentioned asset price characteristics of a model with loss aversion in preferences. As our results show using loss aversion we get considerably better results than one usually obtains from pure consumption-based asset pricing models including the habit formation variant.

Great Moderation(s) and US Interest Rates: Unconditional Evidence

The Great Moderation refers to the fall in US output growth volatility in the mid-1980s. At the same time, the US experienced a moderation in inflation and lower average inflation. Asset pricing theory predicts that moderations -- real or nominal -- influence interest rates. Using annual data since 1890, we find that an earlier 1946 moderation in output and consumption growth was comparable to that of 1984. To assess the impact of these moderations, we also isolate the 1969-1983 Great Inflation using quarterly data since 1947. We examine the quantitative predictions of a consumption-based asset pricing model for shifts in the unconditional average of US interest rates across these time periods. A central finding is that such shifts probably were related to changes in average inflation rather than to moderations in inflation and consumption growth.

Great Moderations and U.S. Interest Rates: Unconditional Evidence

The Great Moderation refers to the fall in U.S. output growth volatility in the mid-1980s. At the same time, the United States experienced a moderation in inflation and lower average inflation. Using annual data since 1890, we find that an earlier, 1946 moderation in output and consumption growth was comparable to that of 1984. Using quarterly data since 1947, we also isolate the 1969-83 Great Inflation to refine the asset pricing implications of the moderations. Asset pricing theory predicts that moderations - real or nominal - influence interest rates. We examine the quantitative predictions of a consumption-based asset pricing model for shifts in the unconditional average of U.S. interest rates. A central finding is that such shifts probably were related to changes in average inflation rather than to moderations in inflation and consumption growth.

Consumption Based Asset Pricing Models: Empirical Performance

Asset pricing is a branch of flnancial economics that is rich in puzzles and anomalies|that is, stylized empirical facts not easily explained by the canonical asset pricing models. These range from the equity premium puzzle and the risk-free rate puzzle to the fact that stock returns are highly predictable. This entry discusses difierent consumption based asset pricing models that have been developed to resolve these puzzles and it evaluates their empirical performance.

Consumption Based Asset Pricing Models: Theory

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 entry discusses this class of models.

Bond Positions, Expectations, and the Yield Curve

Abstract: This paper implements a structural model of the yield curve with data on nominal positions and survey forecasts. Bond prices are characterized in terms of investors' current portfolio holdings as well as their subjective beliefs about future bond payoffs. Risk premia measured by an econometrician vary because of changes in investors' subjective risk premia that are identified from portfolios and subjective beliefs but also because subjective beliefs differ from those of the econometrician. The main result is that investors' systematic forecast errors are an important source of business cycle variation in measured risk premia. By contrast, subjective risk premia move less and more slowly over time. JEL classification: E4, E5, G1 Key words: expectations, surveys, interest rates, portfolio choice, asset positions, term structure, yield curve Working Paper 2008-2 January 2008 I Introduction There is a large literature that tries to understand the dynamics of the yield curve through the behavior of optimizing investors. For example, consumption-based asset pricing models start from the fact that, when investors optimize, bond prices can be expressed in terms of investors' beliefs about future asset values and consumption. Model-implied bond prices then consist of expected discounted future bond payoffs, minus a risk premium that depends on the covariance of future bond returns with consumption. Empirical implementation of this idea requires the modeler to postulate a probability distribution that represents investor beliefs. In practice, this distribution is typically supplied by a stochastic process of asset values and consumption, often constrained by cross- equation restrictions implied by the economic model. This paper proposes an alternative approach to implement a structural model of the yield curve. We start from the fact that, when investors optimize, the prices of bonds can be expressed in terms of the distribution of their future payoffs together with current realized investor asset positions. We construct measures of both objects, using survey expectations of yields as well as data on outstanding nominal assets in the US economy. Model-implied bond prices again depend on expected payoffs minus risk premia, where the latter are identified from beliefs and portfolio holdings. Our model allows for three sources of time variation in expected excess bond returns measured by an econometrician. First, there is time variation in the subjective volatility of investors' consumption growth (or their return on wealth), which we identify from portfolio data. Second, there is time variation in the conditional covariance of bond returns with investors' continuation utility (or investment opportunities), a property of investors' subjective belief. Finally, risk premia measured by an econometrician can vary over time if investors' subjective beliefs do not agree with those of the econometrician. The main result of this paper is that, at least in the model we consider, this third source of time variation in measured expected excess returns is the most important one. We consider a group of investors who share the same Epstein-Zin preferences and hold the same subjective beliefs about future asset payoffs. Our analysis proceeds in four steps. First, we estimate investors' beliefs about future asset values, combining statistical analysis and survey forecast evidence. Second, we produce a measure of investor asset positions, using quantity data from the Flow of Funds accounts and the CRSP Treasury database. Third, we work out investors' savings and portfolio choice problem given beliefs to derive asset demand, for every period in our sample. Finally, we find equilibrium asset prices by setting asset demand equal to investors' observed asset holdings in the data. We thus arrive at a sequence of model-implied bond prices of the same length as the sample. …

Real Interest Rate Persistence: Evidence and Implications

The real interest rate plays a central role in many important financial and macroeconomic models, including the consumption-based asset pricing model, neoclassical growth model, and models of the monetary transmission mechanism. The authors selectively survey the empirical literature that examines the time-series properties of real interest rates. A key stylized fact is that postwar real interest rates exhibit substantial persistence, shown by extended periods when the real interest rate is substantially above or below the sample mean. The finding of persistence in real interest rates is pervasive, appearing in a variety of guises in the literature. The authors discuss the implications of persistence for theoretical models, illustrate existing findings with updated data, and highlight areas for future research. (JEL C22, E21, E44, E52, E62, G12)

State Dependence Can Explain the Risk Aversion Puzzle

Risk aversion functions extracted from observed stock and option prices can be negative, as shown by Ait-Sahalia and Lo (2000), Journal of Econometrics 94: 9-51; and Jackwerth (2000), The Review of Financial Studies 13(2), 433-51. We rationalize this puzzle by a lack of conditioning on latent state variables. Once properly conditioned, risk aversion functions and pricing kernels are consistent with economic theory. To differentiate between the various theoretical explanations in terms of heterogeneity of beliefs or preferences, market sentiment, state-dependent utility, or regimes in fundamentals, we calibrate several consumption-based asset pricing models to match the empirical pricing kernel and risk aversion functions at different dates and over several years.

On the predictive power of the surplus consumption ratio

This paper shows that the surplus consumption ratio, specified by Campbell and Cochrane [1999. Journal of Political Economy 107, 205–251], is a good predictor of excess returns at long horizons. We also provide empirical evidence that this variable captures a component of expected returns, not explained by the proxies for the consumption to wealth ratio, cay and cdy, proposed by Lettau and Ludvigson [2001a. Journal of Finance 56, 815–849; 2001b. Journal of Political Economy 109, 1238–1286; 2005. Journal of Financial Economics 76, 583–626]. Moreover, used as a conditioning information for the Consumption based Asset Pricing Model (C)CAPM, the resulting linear model helps to explain for the variation in average returns across the Fama–French (25) portfolios sorted by size and book-to-market characteristics.

Aggregate stock market behavior and investors’ low risk aversion

This paper studies whether investors’ high risk aversion can be avoided in a representative-agent model that is able to explain aggregate stock market behavior in the US financial market. We present a consumption-based asset pricing model with a representative agent who has a ‘catching up with the Joneses’ preference to show that high risk aversion can be avoided in a representative-agent model that can help explain many of the empirically observed properties of the aggregate stock market return, including the equity premium and risk-free rate puzzles, the predictability of long-horizon stock returns, and the ‘leverage effect’ in return volatility.

Utility-Based Pricing of the Weather Derivatives

Since the underlying of the weather derivatives is not a traded asset, these contracts cannot be evaluated by the traditional financial theory. Cao and Wei (2004) price them by using the consumption-based asset pricing model of Lucas (1978) and by assuming different values for the constant relative risk aversion coefficient. Instead of taking this coefficient as given, we suggest in this paper to estimate it by using the consumption data and the quotations of one of the most transacted weather contracts which is the New York weather futures on the Chicago Mercantile Exchange (CME). We apply the well-known generalized method of moments (GMM) introduced by Hansen (1982) to estimate it as well as the simulated method of moments (SMM) attributed to Lee and Ingram (1991) and Duffie and Singleton (1993). This last method is studied since it is presumed to give satisfactory results in the case of the weather derivatives for which the prices are simulated. We find that the estimated coefficient from the SMM approach must have improbably high values in order to have the calculated weather futures prices matching the observations.