Consumption-based Asset Pricing 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.

Cryptocurrency returns and consumption-based asset pricing

ABSTRACT This paper examines whether the cross-section of cryptocurrency returns is captured by risk factors based on consumption-based asset pricing. It is an imperative task for financial economists to find the fundamental risk behind characteristic-based cryptocurrency factors in order to economically understand cryptocurrency. To address the data availability issue in the analysis of cryptocurrency, we employ mixed data sampling (MIDAS) regression to check the relation between the principal component analysis (PCA) factors in cryptocurrency returns and the factors in the consumption capital asset pricing models (CCAPMs) and intertemporal capital asset pricing models (ICAPMs). We establish significant links between them, which in turn implies that cryptocurrency returns are investors’ compensation for bearing consumption risk, conditional consumption risk, and intertemporal consumption risk. This finding underscores that cryptocurrency returns are the manifestation of macroeconomic equilibrium derived from investors’ utility maximization.

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.

Reference-Dependent Consumption Planning Behaviors: Theory, Evidence, and Implications for Consumption-Based Asset Pricing

Reference-Dependent Consumption Planning Behaviors: Theory, Evidence, and Implications for Consumption-Based Asset Pricing

Carbon dioxide and asset pricing: Evidence from international stock markets

We use carbon dioxide (CO2) emissions growth to measure consumption risk within a consumption-based capital asset pricing model framework. Given the comprehensive worldwide coverage of CO2 emissions, this measure allows us to use the full history of stock market data in the US, Europe, the world, and fifteen international markets. For the US (Europe/the world), we are able to explain the observed equity market premium with a relative risk aversion of 6 (10/12), which is less than half the size of that estimated using the canonical expenditures-based consumption growth measure. The average estimated relative risk aversion across fifteen other international markets is 5. We also find evidence that the growth of CO2 emissions is a priced risk factor that captures the cross section of stock portfolio returns.

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.

Joint inference based on Stein-type averaging estimators in the linear regression model

While averaging unrestricted with restricted estimators is known to reduce estimation risk, it is an open question whether this reduction in turn can improve inference. To analyze this question, we construct joint confidence regions centered at James–Stein averaging estimators in both homoskedastic and heteroskedastic linear regression models. These regions are asymptotically valid when the number of restrictions increases possibly proportionally with the sample size. When used for hypothesis testing, we show that suitable restrictions enhance power over the standard F-test. We study the practical implementation through simulations and an application to consumption-based asset pricing.

Justifying S-Shaped Consumption Utility Functions Using Consumption-Based Asset Pricing

Justifying S-Shaped Consumption Utility Functions Using Consumption-Based Asset Pricing

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.

Warm-glow investment and the underperformance of green stocks

In this paper we develop a novel theory to explain why green stocks should underperform relative to conventional stocks. We assume that investors derive utility from investing in green stocks – what we call “warm-glow” investment. We derive the theoretical implications of these preferences in a model that is an extension of the Consumption-based Capital Asset Pricing Model. We estimate the model using the Generalized Method of Moments. Our estimates of the strength of the preference for warm glow before the financial crisis are statistically significant but economically insignificant; our estimates of it after the crisis are significant both statistically and economically.

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.