Consumption-based Asset Pricing Research Articles

Evidence of persistence in U.S. short and long-term interest rates

This study examines the time series behavior of U.S. short- and long-run real ex-post interest rates within a long memory approach with non-linear trends using a long span of monthly and annual data. Overall, our results suggest that U.S. real interest rates are not as persistent as suggested in the literature. The implications of this result are relevant to evaluate both the effectiveness of policy interventions and the theoretical implications of different macroeconomic and financial models. For example, our results are consistent with the main implications of the consumption-based asset pricing models and the Fisher effect. Furthermore, the results point out to the difficulties of the monetary policy to influence interest rates, mainly in the long-run, and thus, highlighting varied interest rate policies across short and long-runs when it comes to affecting the real economy.

Firm characteristics, consumption risk, and firm-level risk exposures

We propose a novel approach to measuring firm-level risk exposures and costs of equity. Using a simple consumption-based asset pricing model that explains nearly two-thirds of the variation in average returns across 55 anomaly portfolios, we map the relation between exposures to consumption risk and portfolio-level characteristics. We use this relation to calculate exposures to consumption risk at the firm level and show that the calculated consumption risk exposures yield portfolios with large differences in average returns and ex post consumption risk exposures consistent with those predicted by our calculated betas. Further, industry betas and risk premia implied by our procedure display economically intuitive variation over time. Finally, Fama-MacBeth regressions suggest that risk exposures calculated using our procedure dominate those from alternative factor models at explaining cross-sectional variation in returns.

Consumption-based capital asset pricing models: issues and controversies

This paper discusses the issues and controversies surrounding consumption-based capital asset pricing models (CCAPMs). While CCAPMs provide a chance to explain the phenomena observed in stock markets, their viability is jeopardized owing to the weak predictability of the equity premium and risk-free rate puzzles. Even given market frictions and market incompleteness, CCAPMs must test their validity constantly in the face of the formidable challenges of rival models. Measurement error with respect to time aggregation is also regarded as a major threat, causing the low volatility of consumption and eventually resulting in chaining itself to weak return predictability. In addition, the dual choice problem of portfolio and consumption rooted in CCAPMs guides us into how investors accumulate wealth through the financial market to reach the zenith of expected utility. This paper offers insights as well as understanding into the behavior of an agent and market phenomena in the context of a consumption-based economy.

Variance risk premiums and the forward premium puzzle

We provide new empirical evidence that world currency and U.S. stock variance risk premiums have nonredundant and significant predictive power for the appreciation rates of 22 with respect to the U.S. dollar, especially at the four-month and one-month horizons, respectively. The heterogeneous exposures of currencies to the currency variance risk premium are systematically rising along the line of inflation risk. We rationalize these findings in a consumption-based asset pricing model, with local consumption uncertainty and global inflation uncertainty characterized, respectively, by the stock and currency variance risk premiums.

Where’s the Kink? Disappointment Events in Consumption Growth and Equilibrium Asset Prices

I propose a consumption-based asset pricing model with disappointment aversion to investigate the link between downside consumption risk and expected returns across asset markets. I find that the disappointment model can explain 95% of the cross-sectional variation in size/book-to-market portfolios and more than 80% of the variation in the joint sample of stocks, bonds, and commodity futures. I also show that the performance of the disappointment model is comparable to that of the Fama-French three-factor specification, regardless of the sample frequency (annual, quarterly). Overall, my results indicate that disappointment aversion considerably improves the fit of consumption-based asset pricing models.Received November 27, 2014; editorial decision September 18, 2016 by Editor Stefan Nagel.

Asset Pricing with Housing Booms and Disasters

By extending Cumulant Generating Function-based pricing formulas to a two-good economy (non-housing and housing), we obtain closed-form solutions for asset prices. The presence of housing impacts risk aversion and induces time variation that is priced in the model. Since housing also brings about composition risk, we show that it introduces endogenously a long-run risk component into the consumption bundle dynamics. Estimating the model over the period 1959 -– 2020, we show that rare booms and busts events in housing expenditures is determinant in obtaining moderate housing risk premium and housing excess return volatility, both in line with empirical results. The real interest rate and both the level and volatility of the equity risk premium also fit the data owing to the presence of the COVID period into our sample period.

A New Perspective on the Equity Premium Puzzle

The general conclusion of a very large literature on the equity premium puzzle is that the simplest version of the consumption-based asset pricing model (C-CAPM) with time-additive, power utility is inconsistent with the data. I show that this conclusion is premature and the simplest version can account for high equity premium and other puzzles if decision-maker reliance on informative starting points is incorporated in the model.

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.

Snakes and Ladders: Asset Pricing with Household Disasters

Disaster models are typically agnostic as to what spawns tail events, but are often calibrated on labor shocks. Using a novel way to construct rare event factors using the CEX survey data, I study whether the type of idiosyncratic shock modeled matters empirically. I estimate an augmented consumption-based asset pricing model, and find that while labor shocks do come through, they surprisingly do not significantly improve the fit of the model when used on their own, compared to a standard model with no shock factors. I show that including labor shocks with other types of events, notably housing, health and demographic shocks, serves to enhance the goodness-of-fit, reduces the pricing error, and generates plausible parameters for the utility function. The results suggest that labor is indeed a channel of idiosyncratic tail risk for asset pricing models, but the variations of the risk premium are most effectively captured when demographic, housing and health shocks are also included.

Fat Tails and Euler Equations: A Monte Carlo Study

The standard generalized method of moments (GMM) estimation of Euler equations in heterogeneous-agent consumption-based asset pricing models is inconsistent under fat tails because the GMM criterion is asymptotically random. To illustrate this, we generate asset returns and consumption data from an incomplete-market dynamic general equilibrium model that is analytically solvable and exhibits power laws in consumption. Monte Carlo experiments suggest that the standard GMM estimation is inconsistent and susceptible to Type II errors (incorrect non-rejection of false models). Estimating an overidentified model by dividing agents into age cohorts appears to mitigate Type I and II errors.

A Heterogeneous-Agent Foundation of the Representative-Agent Approach

The representative-agent approach is widely used in consumption-based asset pricing. From a theoretical point of view, quite restrictive assumptions on the underlying economy are needed for asset prices to depend only on aggregate consumption. A heterogeneous-agent financial market model is presented with all investors following simple rebalancing rules where aggregation already fails. A meaningful specification of a representative agent is still possible: Instead of asset prices per se the representative agent indicates the direction in which relative asset prices tend to in expectation from one time period to the next. The objective function of the representative agent is independent of the set of rebalancing rules participating in the market.

Informed Trading and Intertemporal Substitution: The Limits of the No-Trade Theorem

I examine the conditions for the no-trade theorem to hold in multiperiod consumption settings and show it no longer holds in many reasonable scenarios. In situations where agents have different concerns for intertemporal substitution, information-based trade can be mutually acceptable because it enables agents to readjust their consumption profiles based on future consumption shocks. I show that the existing literature that finds no-trade results in various multiperiod consumption settings crucially depends on specific preference assumptions that lead to risk aversion dominating concerns for intertemporal substitution. The no-trade theorem fails to hold when a wider range of utility functions with a more important role for intertemporal substitution are considered. Intertemporal substitution bridges information-based trading and consumption-based asset pricing. Consumption-based asset pricing models are natural candidates to analyze information-based trading, and informationbased trading affects the volatility of individual consumption processes. Quantitative analysis demonstrates that besides asset pricing implications, information-based trading related to intertemporal consumption smoothing can also explain a significant part of the trading volume observed in financial markets.

From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors

This paper compares consumption-based asset pricing models based on the forecasting performance of investors who use economic constraints derived from the models to predict the equity premium. Three prominent asset pricing models are considered: Habit Formation, Long Run Risk, and Prospect Theory. I propose a simple Bayesian framework through which the investors impose the economic constraints as model-based priors on the parameters of their predictive regressions. An investor whose prior beliefs are rooted in the Long Run Risk model achieves more accurate forecasts overall. The greatest difference in performance occurs during the bull market of the late 1990s. During this period, the weak predictability of the equity premium implied by the Long Run Risk model helps the investor to not prematurely anticipate falling stock prices.

Ambiguity and Time-Varying Risk Aversion in Sovereign Debt Markets

This paper introduces changes in the level of ambiguity as a complementary source of time-varying risk aversion. We show in a consumption-based asset pricing model with simultaneously risky and ambiguous assets that a rise in the level of ambiguity raises investors' risk aversion. The effect is quantified in an application to European sovereign debt markets using a structural VAR to achieve identification in the data. We proxy for ambiguity using a measure of macroeconomic uncertainty and decompose empirically credit default swaps (CDS) for Spain and Italy into three shocks: fundamental default risk, risk aversion, and uncertainty. We find that shocks to uncertainty significantly increase international investors' risk aversion, accounting for about one fifth of its variation at a five week horizon, and have a significant and economically relevant impact on sovereign financing premia.

"Garbage as an Alternative Measure of Consumption: Evidence from Korea

We find that using garbage as an alternative measure of consumption allows the standard consumption-based asset pricing model to match the observed equity premium with a more reasonable relative risk aversion coefficient than using standard consumption expenditure in Korea. Structural GMM estimation of the risk aversion parameter shows that when garbage is used, the risk aversion estimate ranges from 4.44 to 6.92, and the implied risk-free rate ranges from 3% to 8%. In contrast, when standard consumption expenditure is used, the estimated risk aversion ranges from 12.89 to 18.34, and the implied risk-free rate ranges from 61% to 82%. Overall, our findings suggest that Savov’s (2011) novel idea of using garbage as an indirect measure of consumption is broadly supported by data in Korea.

Testing the Traditional CCAPM in the US: A Revisit

This study re-examines the traditional consumption-based capital asset pricing model (CCAPM) by largely updating US monthly samples of consumption and stock market return and following the methodology of generalized method of moments (GMM) with instrumental variables of Hansen and Singleton (1982). As a result, our investigations reveal the following facts for the US stock market. First, 1) in the cases of the CCAPM with consumption for nondurable goods and the CCAPM with consumption for nondurable goods and services, their discount rate parameters almost always take similar values that are slightly less than one. Next, 2) their risk aversion parameters more stably take small minus values in the CCAPM with consumption for nondurable goods than in the CCAPM with consumption for nondurable goods and services. Third, 3) in our empirical examinations, all estimated CCAPMs with two kinds of consumption are not rejected by the J-tests.

Empirical Asset Pricing with Multi-Period Disasters and Partial Government Defaults

According to the rare disaster hypothesis, the high excess returns that characterize U.S. postwar data resulted because investors ex ante demanded a compensation for possibly disastrous but very unlikely risks that they ex post did not suffer from. Empirical assessments of the rare disaster hypothesis are scarce, and the frequently used assumption that disasters shrink to one-period events is under suspicion of being the driving force behind the hypothesis' success in calibrations. This study uses the simulated method of moments to estimate a consumption-based asset pricing model that accounts for multi-period disasters, partial government defaults, and recursive investor preferences. The estimates are economically plausible, precise, and qualitatively insensitive with respect to different model specifications. Furthermore, the model-implied market Sharpe ratio, mean market return, and equity premium are comparable to the empirical data. The results thus help to restore the nexus between the real economy and financial markets that is implied by the consumption-based asset pricing paradigm.

Uninsured expense shocks and equity premia

This paper analyzes the influences of uninsured expense shocks on the equity premium. We consider a consumption-based asset pricing model where agents face expected expense shocks. When the agents are hit by the shock, they have to consume all of their wealth and leave the financial markets. The numerical results from our calibrated model can match the mean equity premium, the mean risk-free rate, and the volatility of the equity premium observed in the data.

Re-exploring the CCAPM: The Case of US Industry Returns with Different Price Deflators

<p>Extending US samples, this paper re-examines the classic consumption-based capital asset pricing model (CCAPM) by the generalized method of moments (GMM). Our re-exploration using US three industry returns and different price deflators supplies the following evidence. First, 1) regarding the CCAPM using the US consumption for nondurable goods and the deflator of total personal consumption expenditures (PCEs), the discount rate and risk aversion parameters show plausible values; and according to the <em>J</em>-tests, our above first CCAPM is generally supported. Second, 2) as for the CCAPM with the US consumption for nondurable goods and services and the deflator of total PCEs, both discount rate and risk aversion parameters generally exhibit plausible values and our <em>J</em>-tests show that our above second CCAPM is highly supported. Third, 3) as for the CCAPM using the US consumption for nondurable goods and the deflator of the PCEs for nondurable goods, both parameters of the discount rate and risk aversion are highly stable and our <em>J</em>-tests indicate that our above third CCAPM is highly supported. Finally, 4) as regards the CCAPM using the US consumption for nondurable goods and services and the calculated implicit deflator of the PCEs for nondurable goods and services, the parameters of the discount rate generally exhibit plausible values, while the risk aversion parameters are not so stable. However, according to the <em>J</em>-tests, our above fourth CCAPM is also highly supported.</p>

A Re-examination of the Consumption-based Capital Asset Pricing Model: The Case of US and Japan

This paper re-tests the classic consumption-based capital asset pricing model (CCAPM) by extending US quarterly samples and adding the Japanese case. Using the generalized method of moments (GMM) methodology developed by Hansen and Singleton (1982), we obtain the following findings. (1) First, in the case of the CCAPM with consumption for nondurable goods in the US, the discount rate parameters generally show plausible values; however, the risk aversion parameters show unstable values in general. Further, by the J -tests, the estimated CCAPMs with consumption for nondurable goods in the US are always supported. (2) Second, in the case of the CCAPM with consumption for nondurable goods and services in the US, although the parameters of discount rate generally show plausible values, the risk aversion parameters are unstable. In addition, judging the results of the J -tests, all estimated CCAPMs with consumption for nondurable goods and services in the US are supported. (3) Finally, as for the CCAPM with private final consumption expenditures in Japan, the parameters of discount rate take plausible values; on the other hand, the risk aversion parameter values are unstable in general. Regarding the model validity, our estimated CCAPMs for Japan are mostly supported by the J -tests.