Consumption Capital Asset Pricing Model Research Articles

Long-run Consumption Risk and International Stock Returns: A Century of Evidence

We estimate consumption based asset pricing models using consumption and equity market data for fifteen countries from 1900 to 2008 in a setting where investors have recursive utility. We find strong evidence that a long-run risk consumption CAPM that prices international stock returns via their exposures to multi-period consumption growth in world consumption performs considerably better in explaining the international cross-section of returns than the canonical consumption CAPM. By virtue of the long-run data set, we are also able to relate the importance of world consumption risk for the cross-section of international stock returns to periods of high and low capital market integration. It turns out that the extent to which returns are exposed to world consumption growth indeed di ffers across periods: During the early part of our sample period, when international capital mobility was high, stock returns' exposure to world consumption growth is important. Local consumption growth, however, is more important for the post-WWII period when international capital mobility was generally low except for the last two decades.

Can We Resurrect the CAPM in Japan? Evaluating Conditional Asset Pricing Models by Incorporating Time-varying Price of Risk

This paper evaluates conditional asset pricing models for the Japanese stock market by examining time-varying risk pricing. Using a multivariate generalized autoregressive conditional heteroskedasticity (GARCH) model, we tested the conditional versions of the Sharpe (1964)−Lintner (1965)−Mossin (1966) capital asset pricing model (CAPM), the consumption CAPM (CCAPM), and the CAPM with a constant term. The empirical results demonstrate that the price of risk in the conditional CAPM is generally positive and significant. Moreover, our formal panel data tests reveal that the conditional CAPM is never rejected in the case of the 25 book-equity-to-market equity (BE/ME)-ranked portfolios. Furthermore, in the conditional version of the CAPM with a constant term, positive alphas are generally seen in Japan; however, our statistical test of the hypothesis that the average value of the alphas of the conditional CAPM equals zero is never rejected for the 25 BE/ME-ranked portfolios in Japan. This evidence demonstrates that the CAPM can be adequately represented by using the multivariate GARCH model to explain the value premia in Japan.

Land of addicts? an empirical investigation of habit‐based asset pricing models

AbstractThis paper studies the ability of a general class of habit‐based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. We treat the functional form of the habit as unknown, and estimate it along with the rest of the model's finite dimensional parameters. Using quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, that habit formation is better described as internal rather than external, and the estimated time‐preference parameter and the power utility parameter are sensible. In addition, the estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross‐sectional stock return data. We find that an internal habit SDF proxy can explain a cross‐section of size and book‐market sorted portfolio equity returns better than (i) the Fama and French (1993) three‐factor model, (ii) the Lettau and Ludvigson (2001b) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM. Copyright © 2009 John Wiley & Sons, Ltd.

Heterogeneous time varying transaction costs and asset pricing in international equity markets

In this paper, we examine the time variation in transaction costs relative to excess returns, in a panel consisting of 10 international equity indices over the time period 1984–2005. This is undertaken by extending the consumption CAPM (CCAPM) model proposed by Campbell and Shiller (Rev. Financ. Stud. 1:195–228, 1988) to incorporate time varying proportional transaction costs. We rigorously address both the cross-country heterogeneity in the estimated model and endogeneity. We find strong evidence that suggests transaction costs should be included as an additional explanatory variable in the CCAPM. This leads to the conclusion that transaction costs should be included in asset pricing models as their stochastic process impacts directly on private consumption expenditure.

ESTUDO SOBRE A DINÂMICA DO CONSUMPITION CAPITAL ASSET PRINCING MODEL (C-CAPM): UM ESTUDO TEÓRICO

The appearance of Consumption Capital Asset Pricing Model (C-CAPM) happened from the proposition of initial researches of Merton (1973) and Breeden (1979) who aimed to universalize the model Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) and Lintner (1965) in an intertemporal context. The goal of this article was to provide a theoretical base to study the pricing of assets through the C-CAPM. In order to develop the theory, instead of considering a complete generality model, it is necessary at first to establish some limits. For the development of the model it is considered that all the consumers are alike in behavior and have endless life. This consumer will be defined as the representative agent who will determine how the assets will be priced. The methodology applied was a theoretical study about the model dynamics, searching as a result to approach the theory to reality, as being a dynamic model of assets pricing. It was concluded that by using the institution of a representative agent, the C-CAPM is not able to explain empirically the historic data about the return of risk assets, of free assets and, last but not least, of risk award.

Money and the C-CAPM

AbstractWe consider asset pricing in a monetary economy where liquid assets are held to lower transaction costs. The ensuing model extends the capital asset pricing model (CAPM) and the consumption CAPM by deriving real money growth as an additional factor determining returns. Empirically, the two model versions compare favorably to other theoretical asset pricing models along several dimensions, supporting the traditional intertemporal asset pricing perspective. A value premium arises because value firms are sensitive to liquidity shocks but growth firms are not. Although no alternative factor drives out the money growth factor, the conditioning CAY factors of Lettau and Ludvigson (2001b) add explanatory power.

The Real Exchange Rate and its Real Fundamentals: A Story of Success in a Nutshell

Questions regarding the volatility of the real exchange rate, its speed of adjustment to equilibrium, the direction and magnitude of permanent deviations from Purchasing Power Parity, and the relation between real exchange rates and interest rate differentials can all be addressed by models of optimizing behavior founded in the Consumption Capital Asset Pricing Model and the Ramsey-Cass-Koopmans model. As a result, the behavior of the real exchange rate encountered in the data is fully consistent with the fundamentals in these models.

Innovations in Future Labor Income Growth and the Cross-Section of Equity Returns

This paper proposes an Intertemporal Asset Pricing Model (ICAPM) empirical specification which includes innovations related to future labor income growth along with the market factor. The proposed two-factor model can better explain the cross section of average returns than the competing models; the CAPM, the human capital CAPM, the consumption CAPM, LettauLudvigson’s (2001) model, and Vassalou’s (2003) model, and about as well as the Fama and French three-factor model. Innovations in future labor income growth are positively associated with the Fama-French factors SMB and HML, and subsume the explanatory power of the FamaFrench factors in explaining the cross-section of stock returns. These empirical results suggest that the size and value premiums might be compensation for higher exposure to the risk related to innovations in future labor income growth. JEL classification: G12

Long-Horizon Consumption Risk and the Cross-Section of Returns: New Tests and International Evidence

This paper investigates whether measuring consumption risk over long horizons can improve the empirical performance of the Consumption CAPM for size and value premia in international stock markets (US, UK, and Germany). In order to account for commonalities in size and book-tomarket sorted portfolios, we also include industry portfolios in our set of test assets. Our results show that, contrary to the findings of Parker and Julliard (2005), the model falls short of providing an accurate description of the cross-section of returns under our modified empirical approach. At the same time, however, measuring consumption risk over longer horizons typically yields lower risk-aversion estimates. Thus, our results suggest that more plausible parameter estimates - as opposed to lower pricing errors - can be regarded as the main achievement of the long-horizon Consumption CAPM.

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.

Long-Horizon Consumption Risk and the Cross-Section of Returns: New Tests and International Evidence

This paper investigates whether measuring consumption risk over long horizons can improve the empirical performance of the Consumption CAPM for size and value premia in international stock markets (US, UK, and Germany). We modify the estimation approach of Parker and Julliard (2005) taking commonalities in size and book-to-market sorted portfolios into account. Our results show that, contrary to the findings of Parker and Julliard, the model falls short of providing an accurate description of the cross-section of returns under our modified empirical approach. At the same time, however, measuring consumption risk over longer horizons typically yields lower risk-aversion estimates. Thus, our results suggest that more plausible parameter estimates - as opposed to lower pricing errors - can be regarded as the main achievement of the long-horizon Consumption CAPM.

Stock Price with Consumption CAPM: An International Comparison

What is the fundamental value of a stock and do prices deviate from it? This paper answers these questions by using a Consumption-Capital Asset Pricing Model. I first show how to express the fundamental price as a function of expected future dividends and consumption as well as of their future conditional variance and covariance. Secondly, I estimate the fundamental price for the United States, the United Kingdom, Japan and Switzerland from 1965 through to 2006. I focus in particular on the impact of the decreasing inflation observed in this period, through structural changes in dividends and in risk premiums or through money illusion. Thirdly, I show that the gap between the price and its fundamental value decreases after a shock, which suggests a link between them. Finally, I show that forecasts using the fundamental price are more accurate than forecasts based on the observed price only or based on simpler fundamental models.

Failure of Asset Pricing Models: Transaction Cost, Irrationality, or Missing Factors

The reason for the failure of asset pricing models can be divided into three categories: Transaction costs, investor irrationality, or missing risk factors. This study investigates which of the three categories best explains the poor performance of asset pricing models. We regress the differences between the expected return and the realized return on variables related to the failure of asset pricing models. First, we find that both transaction costs and investor irrationality are significantly related to the differences between the realized return and the expected return from the capital asset pricing model (CAPM) even after size and book-to-market are con-trolled. Second, we implement the same testing procedure for the CAPM to other 6 asset pricing models. The results of these regressions are all similar to those for the CAPM. Moreover, most of the Wald tests cannot reject the null hypothesis that the coefficients of asset pricing models are the same except for the consumption CAPM and the conditional CAPM. These results indicate that models with more risk factors than the CAPM cannot improve the CAPM's failure caused by transaction costs and investor irrationality. There-fore, we argue that transaction costs and investor irrationality present a fundamental limit to the improvement of an asset pricing model that cannot be compensated by additional factors.

Using Investment Consumption Value to Select Asset Classes

The asset allocation decision is arguably the most important decision in the investment process. It involves allocating an investor9s portfolio among a set of desirable asset classes, but the investor must first define the asset classes to consider. The concept of investment-consumption value may help investors decide on including non-traditional asset classes such as hedge funds or commodities. The decision framework is grounded in the financial economics of the consumption CAPM and state/preference models. From this perspective, commodities are one example to consider as an investable asset class. <b>TOPICS:</b>Portfolio construction, exchanges/markets/clearinghouses, financial crises and financial market history

New Goods and Asset Prices

I propose an extension to the consumption capital asset pricing model to incorporate the introduction of new goods over time and states of nature. In the model, consumers have a love of variety, and consumption consists of different components: product groups and brands. Expected growth in product groups increases expected future marginal utility - thereby raising the incentive to save and reducing the risk-free rate of interest. Meanwhile, cyclical variation in brand and quality growth makes marginal utility more volatile and countercyclical - thereby raising the expected equity premium.

New Goods and Asset Prices

Abstract I extend the consumption capital asset pricing model to incorporate expanding product variety over time and states of nature. In the model, consumers have a love of variety, and consumption consists of different components: product groups and brands. By raising future marginal utility, growth in product groups increases the incentive to save and reduces the risk-free rate. By making marginal utility more volatile, variation in brand and quality growth magnifies consumption risk and raises the equity premium. Embedding new goods in a long-run risk setting has similar implications.

Macroeconomic Volatility, Predictability, and Uncertainty in the Great Moderation

I examine the extent to which the large decline in observed real output volatility, that is, the great moderation, can be attributed to changes in macroeconomic uncertainty and macroeconomic predictability using forecasts of future real output growth from the Survey of Professional Forecasters (SPF). The results indicate that both predictability and uncertainty have declined over the great moderation. The results indicate that measuring the decline in macroeconomic uncertainty with the volatility of shocks from a fixed-parameter autoregressive model overstates the decline in uncertainty by between 20% and 25%. I examine how this overstatement affects predictions of the equity premium in the consumption capital asset pricing model (CCAPM), and I relate the decline in predictability to a significant change in the relationship between SPF forecasts and key measures of current macroeconomic performance.

Asset Pricing Implications of Investor Inertia

The objective of this paper is to investigate whether infrequent adjustment to information affects the empirical performance of the Consumption Capital Asset Pricing Model. For this purpose, I analyze an economy with a representative investor who observes the changes of one state variable, the expected rate of aggregate dividend growth, infrequently and at regular time intervals. As a consequence, she reacts to economic shocks with an average delay and appears inert to the arrival of new information. The first finding is that information inertia decreases average prices and hence increases average raw returns, causing positive pricing errors. The pricing errors exhibit a seasonal behavior, but do not vanish each time that the representative investor makes an observation. On the contrary, measuring returns on dates other than the observation date usually results in better performance of the consumption model. The main finding of the paper is that, if investors are inert or if information arrives to them in lumps, the econometrician should sample returns before new information becomes available in the economy.

Consumption Risk Over the Frequency Domain

In this paper we extend the concept of ultimate consumption risk analyzed by Parker and Julliard (Journal of Political Economy, 2005), and we evaluate the Consumption Capital Asset Pricing Model by employing as an explanatory variable consumption risk over the frequency domain. We find that at lower frequencies consumption risk explains up to 98% of the cross-sectional variation of expected returns and the equity premium puzzle is resolved. Our evidence is consistent with a coefficient of risk aversion between 1 and 4 in the very long run.

High-Order Consumption Moments and Asset Pricing

This paper investigates the role of the deviations of individual consumption from per capita consumption in explaining the equity premium. We propose the stochastic discount factor that depends on the moments of the cross-sectional distribution of consumption. Using data from the CEX, we find that not only the mean, as in the representative-agent consumption CAPM, but also the second and third cross-sectional moments of consumption are important determinants of the equity premium. The stochastic discount factor that captures the first three cross-sectional moments of consumption explains the observed mean equity premium with a low (below three) value of risk aversion.