Consumption-based Asset Pricing Model Research Articles

Disappearing Money Illusion

In long-term US stock market data the price-dividend ratio strongly predicts future inflation with a positive slope coefficient up to the mid 1970s. Thereafter, the predictability turns negative. We argue that this phenomenon reflects money illusion that disappears during the 1970s. We develop a consumption-based asset pricing model with recursive preferences and either money illusion or inflation non-neutrality that can explain the predictive patterns. The model is also consistent with a structural shift around the mid 1970s in the real interest rate - inflation relationship, thus supporting the hypothesis of disappearing money illusion at that time.

Utility Function with Dis-Utility Shocks - Asset Pricing Implications

It is an unfortunate, yet unmistakable fact that human life can sometimes be unusually painful: loss of loved ones, divorce, critical medical issues just to name a few. I introduce the notion of 'dis-utility shocks': rare but large negative deviations from consumption-based utility level, to represent such uncommon adversities. I adjoin dis-utility shocks to a standard consumption-based asset pricing model and develop a method to compute their impact on asset prices numerically. Despite their idiosyncratic nature, calibration results indicate that dis-utility shocks affect asset prices in ways that address the main puzzles regarding stock price movements.

CAPM-anomalies: quantitative puzzles

The stochastic discount factor is a crucial determinant of the equity premium as well as the cross-sectional distribution of stock returns. This gives rise to the idea that there is a tight link between the equity premium puzzle and cross-sectional asset pricing puzzles. This paper examines similarities between the low-beta premium, the value premium, the small-size premium and the equity premium in a special case of a static consumption-based asset pricing model with constant relative risk aversion and lognormal dividends that can be solved in closed form. The results show that cross-sectional asset pricing puzzles are quantitative puzzles just like the equity premium puzzle: The model generates a premium for stocks with a low beta, a high dividend-price ratio and a small market capitalization but the size of the premium is too small. Furthermore, the size of the premium rises together with the equity premium as the risk aversion coefficient or consumption risk is increased.

Do Consumption-Based Asset Pricing Models Explain Serial Dependence in Stock Returns?

We show that three prominent consumption-based asset pricing models - the Bansal-Yaron, Campbell-Cochrane and Cecchetti-Lam-Mark models - cannot explain the own-history predictability 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. Furthermore, a semi-parametric test suggests that lagged returns have too much predictive power over current returns to be consistent with the state variables which explain market returns being the same as the state variables which explain market returns in any of the three models.

A two-step indirect inference approach to estimate the long-run risk asset pricing model

The long-run consumption risk model provides a theoretically appealing explanation for prominent asset pricing puzzles, but its intricate structure presents a challenge for econometric analysis. This paper proposes a two-step indirect inference approach that disentangles the estimation of the model’s macro-economic dynamics and the investor’s preference parameters. A Monte Carlo study explores the feasibility and efficiency of the estimation strategy. We apply the method to recent U.S. data and provide a critical re-assessment of the long-run risk model’s ability to reconcile the real economy and financial markets. This two-step indirect inference approach is potentially useful for the econometric analysis of other prominent consumption-based asset pricing models that are equally difficult to estimate.

A two-step indirect inference approach to estimate the long-run risk asset pricing model

Abstract The long-run consumption risk model provides a theoretically appealing explanation for prominent asset pricing puzzles, but its intricate structure presents a challenge for econometric analysis. This paper proposes a two-step indirect inference approach that disentangles the estimation of the model’s macro-economic dynamics and the investor’s preference parameters. A Monte Carlo study explores the feasibility and efficiency of the estimation strategy. We apply the method to recent U.S. data and provide a critical re-assessment of the long-run risk model’s ability to reconcile the real economy and financial markets. This two-step indirect inference approach is potentially useful for the econometric analysis of other prominent consumption-based asset pricing models that are equally difficult to estimate.

How Does Stochastic Volatility Influence Asset Prices? A Parameter-Free Approach

We disentangle the risk of time-varying volatility and return in a consumption-based asset pricing model by introducing stochastic volatility of consumption growth to asset prices moving in volatility units instead of moving in time. This time-change approach yields additional insights to risk premia’s composition. We explore stochastic volatility empirically where it eases the risk-free rate puzzle and solves the equity premium puzzle if people are very impatient. As a factor it significantly improves the explanation of returns in the cross-section and is not captured by existing factors. Adding our factor helps to explain the momentum effect among other anomalies.

Doubts and variability: A robust perspective on exotic consumption series

Consumption-based asset-pricing models have experienced success in recent years by augmenting the consumption process in ‘exotic’ ways. Two notable examples are the Long-Run Risk and rare disaster frameworks. Such models are difficult to characterize from consumption data alone. Accordingly, concerns have been raised regarding their specification. Acknowledging that both phenomena are naturally subject to ambiguity, we show that an ambiguity-averse agent may behave as if Long-Run Risk and disasters exist even if they do not or exaggerate them if they do. Consequently, prices may be misleading in characterizing these phenomena since they encode a pessimistic perspective of the data-generating process.

Consumption Volatility Ambiguity and Risk Premium's Time-Variation

In a consumption based asset pricing model one can calculate the volatility of (log-)consumption-growth from the expected market return and from the risk-free rate. We propose to use the difference between these estimates to measure ambiguity about consumption volatility. Using a long dataset we show that this measure explains up to 69% of post-war variation in the market risk premium.

Macroeconomic Tail Risks and Asset Prices

I document that dividend growth and returns on the aggregate U.S. stock market are more correlated with consumption growth in bad economic times. In a consumption-based asset pricing model with a generalized disappointment averse investor and small, IID consumption shocks, this feature results in a realistic equity premium despite low risk aversion. The model is consistent with the main facts about stock market risk premia inferred from equity index options, remains tightly parameterized, and allows for analytical solutions for asset prices. An extension with non-IID dynamics accounts for excess volatility and return predictability while preserving the model's consistency with option moments.

Asset Prices and No-Dividend Stocks

We develop a stationary model of the aggregate stock market featuring both dividend-paying and no-dividend stocks within a familiar, parsimonious consumption-based equilibrium framework. We find that such a simple feature leads to profound implications supporting several stock market empirical regularities that leading consumption-based asset pricing models have difficulty reconciling. We show that the presence of no-dividend stocks in the stock market leads to a lower correlation between the stock market return and aggregate consumption growth rate, a non-monotonic and even a negative relation between the stock market risk premium and its volatility, and a downward sloping term structure of equity risk premia. When we quantify these effects, we find them to be economically significant. We also find that no-dividend stocks command lower mean returns but have higher return volatilities and higher market betas than comparable dividend-paying stocks, consistently with empirical evidence. We provide straightforward intuition for all these results and the underlying economic mechanisms at play.

Probability Weighting and Default Risk: A Solution for Asset Pricing Puzzles

This paper suggests incorporating investor probability weighting and the default risk of individual firms into a consumption-based asset pricing model. The extended model provides a unified solution for several anomalous patterns observed on financial markets. The analysis addresses not only widely-recognized asset pricing puzzles, such as the equity premium puzzle, but also less studied anomalies on financially distressed stocks. The simulation, under which the model is calibrated according to U.S. historical data, shows the combination of mild overweighting of probability on tail events and nonlinearity of equity values caused by default risk has the potential to resolve these patterns.

Equity return predictability, time varying volatility and learning about the permanence of shocks

I consider a consumption based asset pricing model where the consumer does not know if shocks to dividends are stationary (temporary) or non-stationary (permanent). The agent uses a Bayesian learning algorithm with a bias towards recent observations to assign probability to each process. While the true process is stationary, the consumer’s beliefs change as he misinterprets a drift in dividends from their steady state value as an increased likelihood that the dividend process is non-stationary. Belief changes result in large swings in asset prices which are subsequently reversed. The model then is consistent with a broad array of asset pricing puzzles. It predicts the negative correlation between current returns and future returns and the PE ratio and future returns. Consistent with the data, I also find that consumption growth negatively correlates with future returns and the PE ratio and consumption growth forecast future consumption growth. The model amplifies return volatility over the benchmark rational expectations case and exactly matches the standard deviation of consumption. Finally, the model generates time varying volatility consistent with the data on quarterly equity returns.

Ignorance and Indifference: Decision-Making in the Lab and in the Market. (Supplement)

Full paper available at: https://ssrn.com/abstract=3118395 These supplemental materials include additional bibliographical and technical details on the themes brought up in the main text: the consumption-based asset pricing models, as well as the concept of shrinkage. A description of data sources is also given here.

Estimating the Dynamics of Consumption Growth

We estimate models of consumption growth that allow for long-run risks and disasters using data for a series of countries over a time span of 200 years. Our estimates indicate that a model with small and frequent disasters that arrive at a mean-reverting rate best fits international consumption data. The implied posterior disaster intensity in such a model predicts equity returns without compromising the unpredictability of consumption growth. It also generates time-varying excess stock volatility, empirically validating key economic mechanisms often assumed in consumption-based asset pricing models.

Equilibrium Yield Curve, the Phillips Curve, and Monetary Policy

Upward sloping yield curves are hard to reconcile with the positive association between income and inflation (the Phillips curve) in consumption-based asset pricing models. Using US and UK data, this paper shows inflation is negatively correlated with long-run income growth but positively correlated with cyclical income, thus enabling the model to replicate positive and sizable term premiums, along with the Phillips curve over business cycles. Quantitative analyses also emphasize the importance of monetary policy, predicting that a permanently low growth and low inflation environment would precipitate flatter yield curves due to constraints to monetary policy around the zero lower bound.

The predictability implied by consumption-based asset-pricing models: a review of the theory and empirical evidence

This paper examines whether two well-known models, Campbell and Cochrane’s habit model (1999) and Bansal and Yaron’s long-run risks model (2004), can produce significant return predictability. We find that a state variable, the surplus consumption ratio in the habit model, explains the countercyclical time-varying risk premium. In the long-run risks model, the main sources of volatility in the price–dividend ratio are a persistent and predictable consumption growth rate and economic uncertainty. Following Kirby’s work in 1998, we test whether the two models can explain the observed risk, ie, return volatility. Both models fail to generate any significant predictive power. However, the habit model exhibits relatively strong volatility, which implies that variation in the expected excess returns is largely attributable to the time-varying risk aversion.

X-CAPM REVISITED: THE INSTITUTIONAL EXTRAPOLATIVE CAPITAL ASSET PRICING MODEL (I-X-CAPM)

This study constructs and tests a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by extrapolating past price changes, while other investors hold fully rational beliefs. The contribution of the present work is the inclusion of institutional investor bias. As such it extends theory. But it also conducts econometric tests by using daily survey data on individual and institutional investors’ sentiment on the current economic situation and their future expectations. Empirical findings may imply that institutions’ sentiment reverts quicker to the equilibrium price than individual sentiment, at least with regard to their beliefs on future economic outlook. If studied further with a bigger dataset, it may imply that institutional investors are closer to the rational-decision making mechanism compared to individual investors. The theoretical framework rests on prospect theory. The market studied is the US equity market, however findings and suggestions can be applied to global markets and various financial instruments.

Does Smooth Ambiguity Matter for Asset Pricing?

We use the Bayesian method introduced by Gallant and McCulloch (2009) to estimate consumption-based asset pricing models featuring smooth ambiguity preferences. We rely on semi-nonparametric estimation of a flexible auxiliary model in our structural estimation. Based on the market and aggregate consumption data, our estimation provides statistical support for asset pricing models with smooth ambiguity. Statistical model comparison shows that models with ambiguity, learning and time-varying volatility are preferred to the long-run risk model. We analyze asset pricing implications of the estimated models.

A flexible approach to estimate the equity premium

ABSTRACTIn this article, we estimate the risk aversion for households accounting for their lifetime consumption risk. Households take into account the overall lifetime uninsured consumption risk when optimizing their resources, which based on micro data varies across households. Thus, representing households’ consumption by merging cross-sectional micro data into the single Euler equation (the common approach for estimating risk aversion based on consumption-based asset pricing theory) may be too rough an approximation, leading to biased results with respect to risk aversion. Our results suggest that consumption-based asset pricing models that were rejected in several studies do in fact fit the data when we account for households’ lifetime consumption risk. This finding also has implications for long-run aggregate consumption-based asset pricing models.