Using long-run consumption-return correlations to test asset pricing models (original) (raw)
Related papers
2007
Abstract This paper examines a new set of implications of existing asset pricing models for the correlation between returns and consumption growth over the short and the long run. The findings suggest that external habit formation models face a challenge in producing two robust facts in aggregate data, namely, that stock market returns lead consumption growth, and that the correlation between returns and consumption growth is higher at low frequencies than it is at high frequencies.
Consumption asset pricing models: Evidence from the UK
We analyse the ability of the consumption-based capital asset pricing model (C-CAPM) using traditional power utility, the recursive preferences model proposed by Epstein and Zin and two habit formation specifications proposed by Abel and Campbell and Cochrane to explain asset returns at both the economy level and, novelly, four individual sector groupings. We also investigate whether the models are capable of explaining the variation in the Fama–French factors. We find evidence supportive of both the habit formation specifications and the traditional power utility C-CAPM. The Epstein–Zin specification is clearly rejected. The preferred specification is that of Campbell and Cochrane. Importantly, parameter estimates for the sector groupings are consistent with theory, suggesting risk aversion is the same in all sectors. However, the ability of the models to describe the behaviour of the Fama–French factors is mixed.
Don’t break the habit: structural stability tests of consumption asset pricing models in the UK
Applied Economics Letters, 2005
This paper investigates the structural stability of four alternative consumption based asset pricing models, the traditional power utility consumption based capital asset pricing model (C-CAPM), the recursive preferences model proposed by Epstein and Zin (1989, 1991), and two habit formation specifications, the form proposed by Abel (1990) and the model of Campbell and Cochrane (1999), using the tests of Hall and Sen (1999). The ability of the models to price stocks and stocks and a short-term interest rate (i.e., the equity premium) is assessed. Evidence is found supportive of both the habit formation specifications and the traditional C-CAPM. The preferred specification based on parameter estimates and structural stability is that of Campbell and Cochrane.
Asset pricing models with and without consumption data: An empirical evaluation
Journal of Empirical Finance, 1996
This paper evaluates the ability of the empirical model of asset pricing of Campbell (1993a,b) to explain the time-series and cross-sectional variation of expected returns of portfolios of stocks. In Campbell's model, an alternative risk-return relationship is derived by substituting consumption out of the linearized first-order condition of the representative agent. We compare this methodology to models that use actual consumption data, such as the model of Epstein and Zin, 1989, 1991, and the standard consumption-based CAPM. Although we find that Campbell's model fits the data slightly better than models which explicitly price consumption risk, and provides reasonable estimates of the representative agent's preference parameters, the parameter restrictions of the Campbell model, as well as its overidentifying orthogonality conditions, are generally rejected. The parameter restrictions of the Campbell model, and the overidentifying conditions, are marginally not rejected when the empirical model is augmented to account for the "size effect".
Habit formation, surplus consumption and return predictability: International evidence
Journal of International Money and Finance, 2010
On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.
The wealth-consumption ratio: A litmus test for consumption-based asset pricing models
2007
We propose a new method to measure the wealth-consumption ratio. We estimate an exponentially affine model of the stochastic discount factor on bond yields and stock returns and use that discount factor to compute the no-arbitrage price of a claim to aggregate US consumption. We find that total wealth is much safer than stock market wealth. The consumption risk premium is only 2.2%, substantially below the equity risk premium of 6.9%. As a result, our estimate of the wealth-consumption ratio is much higher than the price-dividend ratio on stocks throughout the postwar period. The high wealth-consumption ratio implies that the average US household has a lot of wealth, most of it human wealth. The wealthconsumption ratio also has lower volatility than the price-dividend ratio on equity. A variance decomposition of the wealth-consumption ratio shows that future returns account for most of its variation. The predictability is mostly for future interest rates, not future excess returns. We conclude that the properties of total wealth are more similar to those of a long-maturity bond portfolio than those of a stock portfolio. Many dynamic asset pricing models require total wealth returns as inputs, but equity returns are commonly used as a proxy. The differences we find between the risk-return characteristics of equity and total wealth suggest that equity is special.
Asset Pricing Models with and without Consumption: An Empirical Evaluation
Cepr Discussion Papers, 1995
This paper evaluates the ability of the empirical model of asset pricing of Campbell (1993a,b) to explain the time-series and cross-sectional variation of expected returns of portfolios of stocks. In Campbell's model, an alternative risk-return relationship is derived by substituting consumption out of the linearized first-order condition of the representative agent. We compare this methodology to models that use actual consumption data, such as the model of Epstein and Zin, 1989, 1991, and the standard consumption-based CAPM. Although we find that Campbell's model fits the data slightly better than models which explicitly price consumption risk, and provides reasonable estimates of the representative agent's preference parameters, the parameter restrictions of the Campbell model, as well as its overidentifying orthogonality conditions, are generally rejected. The parameter restrictions of the Campbell model, and the overidentifying conditions, are marginally not rejected when the empirical model is augmented to account for the "size effect".
Predictability in Consumption Growth and Equity Returns: A Bayesian Investigation
Financial Review, 2010
In the last couple of decades, researchers have discovered a number of asset pricing "puzzles" that cannot be understood in isolation. For example, described the "equity premium puzzle" as "too high" expected excess asset returns. This phenomenon could be resolved by increasing the level of risk aversion, but that would create the "risk-free rate puzzle" documented by . It would be impossible to reconcile the high level of risk-aversion with the low level of interest rate. A third important puzzle is the fact that the unconditional volatility of real stock returns has been excessively high relative to the unconditional volatility of the real consumption growth. This is the "equity volatility puzzle" documented by .
Consumption, asset markets, and macroeconomic fluctuations
Carnegie-Rochester Conference Series on Public Policy, 1982
A broad exploratory data analysis is conducted to assess the promise of a kind of model in which long-term asset prices change through time primarily due to consumption related changes in the rate of discount. Aggregate consumption data are used to infer ex-post marginal rates of substitution. Prices of stocks, bonds, short debt, land and housing are examined for the period 1890 to 1980. Methods are explored of evaluating this kind of model in the absence of accurate data on consumpticn.
SSRN Electronic Journal, 2000
This work develops an external habit model of the equity premium subject to long run risk in continuous time. The solution to this model is an analytic price-dividend function of the surplus consumption ratio and the long run risk variable. As a result, the equity premium can be accurately approximated by a two variable higher order Taylor polynomial within the region of convergence for the price-dividend function. Numerical evidence shows that this region of convergence is large enough to cover 99.37% of the observations in a Monte Carlo simulation. In this simulation, the equity premium and its standard deviation match the historic observations in the U.S. In addition, the autocorrelations and variance ratios support long term mean reversion in the equity premium.