This paper evaluates the central insight of the consumption capital asset pricing model that an asset’s expected return is determined by its equilibrium risk to consumption. Rather than measure risk by the contemporaneous covariance of an asset’s return and consumption growth, we measure risk by the covariance of an asset’s return and consumption growth cumulated over many quarters following the return. While contemporaneous consumption risk explains little of the variation in average returns across the 25 Fama‐French portfolios, our measure of ultimate consumption risk at a horizon of three years explains a large fraction of this variation.

/pdf/consumption-risk-and-the-cross-section-of-expected-returns-55rv2k50i0.pdf

Consumption Risk and the Cross Section of Expected Returns

Monetary policy and the term structure of nominal interest rates: Evidence and theory☆

When consumption betas of stocks are computed using year-over-year consumption growth based upon the fourth quarter, the consumption-based asset pricing model (CCAPM) explains the cross-section of stock returns as well as the Fama and French (1993) three-factor model. The CCAPM's performance deteriorates substantially when consumption growth is measured based upon other quarters. For the CCAPM to hold at any given point in time, investors must make their consumption and investment decisions simultaneously at that point in time. We suspect that this is more likely to happen during the fourth quarter, given investors' tax year ends in December.

/pdf/lazy-investors-discretionary-consumption-and-the-cross-4dqdkbho4c.pdf

Lazy Investors, Discretionary Consumption, and the Cross‐Section of Stock Returns

If decision costs lead agents to update consumption every D periods, then econometricians will find an anomalously low correlation between equity returns and consumption growth (Lynch 1996). We analytically characterize the dynamic properties of an economy composed of consumers who have such delayed updating. In our setting, an econometrician using an Euler equation procedure would infer a coefficient of relative risk aversion biased up by a factor of 6D. Hence with quarterly data, if agents adjust their consumption every D =4 quarters, the imputed coefficient of relative risk aversion will be 24 times greater than the true value. High levels of risk aversion implied by the equity premium and violations of the Hansen-Jagannathan bounds cease to be puzzles. The neoclassical model with delayed adjustment explains the consumption behavior of shareholders. Once limited participation is taken into account, the model matches most properties of aggregate consumption and equity returns, including new evidence that the covariance between ln(Ct+h/Ct) and Rt+1 slowly rises with h.

/pdf/the-6d-bias-and-the-equity-premium-puzzle-4ds7kl91lj.pdf

The 6D Bias and the Equity Premium Puzzle

Aggregate expenditure on durable goods responds too slowly to wealth and other aggregate innovations to be consistent with the simplest frictionless version of PIH (permanent income hypothesis) In this paper I present a model of aggregate expenditure on durab1es that builds up from the lumpy nature of microeconomic purchases, and provide evidence supporting its contribution to the resolution of the ?slowness? puzzle The paper also contains several new results on the problem of dynamic aggregation of stochastically heterogeneous units In particular, I provide a simple characterization of the effects of heterogeneity and microeconomic lumpiness on aggregate dynamics

Durable Goods: An Explanation for Their Slow Adjustment

We investigate Grossman and Laroque's (1990) conjecture that costs of adjusting consumption can account, in part, for the empirical failure of the consumptionbased capital asset pricing model (CCAPM). We incorporate small fixed costs of consumption adjustment into a CCAPM with heterogeneous agents. We find that undetectably small consumption adjustment costs can account for much of the discrepancy between the observed variance of nondurable aggregate consumption growth and the predictions of the CCAPM, and can partially reconcile nondurable consumption data with the observed equity premium. We conclude that the CCAPM's implications are nonrobust to extremely small adjustment costs. THE CONSUMPTION-BASED CAPITAL ASSET PRICING MODELS (CCAPMs)1 of Lucas (1978), Breeden (1979), and Grossman and Shiller (1982) have difficulty matching the high volatility of equity returns and the high mean equity premium found in U.S. data. First, the variance of the CCAPM asset pricing kernel is too low to generate plausible equity-return volatility. More precisely, Hansen and Jagannathan (1991) and Cochrane and Hansen (1992) show that, for any conjectured pricing kernel mean, the variance of the kernel is too low to satisfy the Hansen-Jagannathan bounds without implausibly high risk aversion or substantial habit formation.2 Second, the covariance between the CCAPM asset pricing kernel and excess equity returns is too low to generate a plausible equity premium. More precisely, let us define EP' as follows:

Can Costs of Consumption Adjustment Explain Asset Pricing Puzzles

The effect of costly consumption adjustment on asset price volatility

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Can Costs of Consumption Adjustment Explain Asset Pricing Puzzles

The effect of costly consumption adjustment on asset price volatility