A flexible approach to estimate the equity premium

In this article, we estimate the risk aversion for households accounting for their lifetime consumption risk. Households take into account the overall lifetime uninsured consumption risk when optimizing their resources, which based on micro data varies across households. Thus, representing households’ consumption by merging cross-sectional micro data into the single Euler equation (the common approach for estimating risk aversion based on consumption-based asset pricing theory) may be too rough an approximation, leading to biased results with respect to risk aversion. Our results suggest that consumption-based asset pricing models that were rejected in several studies do in fact fit the data when we account for households’ lifetime consumption risk. This finding also has implications for long-run aggregate consumption-based asset pricing models.     

An analysis of the consumption risk and asset returns of Chinese residents

The research on the consumption-based asset pricing theory is limited to the developed capital markets. This paper seeks to extend the research to the Chinese developing capital market. It analyzes the dynamic relationship between the Chinese residents’ consumption, stock market returns and interest rates with the CCAPM. According to the analyses of this paper, the IV regression results are mixed. However, the data can fit the model relatively well, and the empirical results fail to reject the model. Thus, the results show that a relationship between the Chinese residents’ consumption growth rates and the asset returns does indeed exist, and that the consumption volatility risk could influence the asset returns.     

中国居民消费、习惯偏好与资产收益研究

习惯模型是行为资产定价理论的重要组成部分,该模型将经济主体的习惯因素纳入到资产定价之中,由此推进了消费资本资产定价理论的发展。习惯模型已经在欧美等国家和地区得到了广泛研究,而在资本市场蓬勃发展的中国则处于被人遗忘的尴尬境地。本文利用外在习惯偏好模型对我国居民消费、习惯偏好与资产收益进行分析。GMM结果是混合性的,模型可以较好地拟合数据,GMM结果无法否定外在习惯偏好模型,因而无法否定习惯因素在消费与资产收益分析中的重要性。     

Using long-run consumption-return correlations to test asset pricing models

This paper examines a new set of implications for existing asset pricing models regarding the correlation between returns and consumption growth over both the short run 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. To reconcile these facts with a consumption-based model, I demonstrate the need for focusing on models that contain a forward-looking consumption component, i.e., models that allow for both trend and cyclical fluctuations in consumption, and that link returns to cyclical fluctuations in consumption. Long-run risk models provide examples of models that contain this consumption component.     

Multifactor consumption based asset pricing models using the US stock market as a reference: Evidence from a panel of developed economies

This article considers a panel framework to test consumption based asset pricing models driven by a US stock market reference for a number of developed economies. Specifically, we focus on a linearized form of what might be seen as a consumption-based capital asset pricing model in a pooled cross section panel with two-way error components. The empirical findings of this multifactor model using a range of specifications indicate that there is a significant unobserved heterogeneity captured by cross-country fixed effects when consumption growth is treated as a common factor. However, the cross-sectional impact of home consumption growth can vary over the countries, where unobserved heterogeneity in the rate of risk aversion can also be addressed by random effects.     

CAN FINANCING CONSTRAINTS EXPLAIN THE ASSET PRICING PUZZLES IN PRODUCTION ECONOMIES?*

General Equilibrium asset pricing models have a difficult time simultaneously delivering a sizable equity premium, a low and counter cyclical real risk free rate, and cyclical variation in return volatility. To explain these stylized facts, this article introduces occasionally binding financing constraints that impede producers’ ability to invest. The financial frictions drive a wedge between the marginal rate of substitution and firms’ internal stochastic discount factors so that the shadow value of capital is not tied to the average price of capital. The model delivers higher and more volatile asset returns during recessions as well as a counter cyclical equity premium.     

Asset pricing in an Islamic economy

ABSTRACT

We define an Islamic economy as one with borrowing restrictions, no leverage, and no risk-free asset. We derive a consumption-based asset pricing model for this economy under standard preferences. We demonstrate that news to consumption growth is the main driver of Islamic financial markets, but the degree of borrowing constraints also affects the pricing of Islamic assets. Using Saudi Arabian data, simulations show that our model does a good job in matching the observed equity premium as well as the volatility of the market return. Our model implies that the price-dividend ratio predicts dividend growth, and as a result that prices are driven mainly by cash-flow news rather than by discount rate news. Empirical tests show that our model is consistent with the data.     

Estimating the elasticity of intertemporal substitution taking into account the precautionary savings motive

This paper estimates the elasticity of intertemporal substitution for U.S. aggregate time series data, taking into account the precautionary savings motive. By making use of a recursive utility function, we estimate an Euler equation, via GMM. This procedure leads consumption growth rate to depend on asset returns, and on a time-varying variance, which captures the precautionary motive. When significant, the elasticity of intertemporal substitution estimates ranges from 0.4 to 1.8, which are higher than most of the results found in the literature. Furthermore, the evidence suggests that consumers react to risk; however, the contribution of precautionary motive to consumption growth seems to be limited.     

Is dynamic general equilibrium a theory of everything?

Should we interpret the contributions of Edward C. Prescott and his collaborators, especially Finn Kydland and Rajnish Mehra, to dynamic general equilibrium as just a mathematical restatement of pre-Keynesian business cycle theory in the language of Arrow and Debreu? This essay advances the contrary view that Prescott has been laying the foundations for a theory of everything in macroeconomics that will stretch well beyond the frictionless environments treated in its early version. A theory of everything is an attempt to explain key empirical observations in nearly every subfield of macroeconomics from a simple, logically coherent conceptual platform with a minimum of institutional detail. After reviewing the current state of Prescott’s agenda, we examine several examples of dynamic equilibrium in economies with constant returns to scale, complete markets, idiosyncratic productivity shocks, and limited capital mobility. These examples suggest that the Solow residual controls the entire path of aggregate output if redefined more broadly to include financial, distributional and institutional variables; that the discount factor used in pricing streams of income will shift autonomously over time in response to endogenous changes in the set of unconstrained asset traders; and that a dynamic general equilibrium model with substantive frictions in financial markets goes some distance towards a joint account of well-known empirical anomalies in growth, business cycles, and asset returns.     

Rational Pessimism, Rational Exuberance, and Asset Pricing Models

The paper estimates and examines the empirical plausibility of asset pricing models that attempt to explain features of financial markets such as the size of the equity premium and the volatility of the stock market. In one model, the long-run risks (LRR) model of Bansal and Yaron, low-frequency movements, and time-varying uncertainty in aggregate consumption growth are the key channels for understanding asset prices. In another, as typified by Campbell and Cochrane, habit formation, which generates time-varying risk aversion and consequently time variation in risk premia, is the key channel. These models are fitted to data using simulation estimators. Both models are found to fit the data equally well at conventional significance levels, and they can track quite closely a new measure of realized annual volatility. Further, scrutiny using a rich array of diagnostics suggests that the LRR model is preferred.     

New approach to estimating the cost of common equity capital for public utilities

The regulatory process for setting public utilities’ allowed rate of return on common equity has generally used the Gordon DCF, CAPM and Risk Premium specifications to estimate the cost of common equity. Despite the widely known problems with these models, there has been little movement to adopt more recently developed asset pricing models to provide additional evidence for estimating the cost of capital. This paper presents, validates empirically and applies a general yet simple consumption-based asset pricing specification to model the risk-return relationship for stocks and estimate the cost of common equity for public utilities. The model is not necessarily superior to other models in its practical results, yet these results do indicate that it should be used to provide additional estimates of the cost of common equity. Additionally, the model raises doubts as to whether assets such as utility stocks are a consumption (business cycle) hedge.     

An examination of the economic significance of stock return predictability in UK stock returns

We explore the out-of-sample performance of domestic UK asset allocation strategies that use forecasts of expected returns from a linear predictive regression and those that are implied by asset pricing models such as the capital asset pricing model (CAPM) or arbitrage pricing theory (APT). Our findings suggest that using forecasts of expected returns from the predictive regression generate significant benefits in out-of-sample performance. We find the performance of the strategies using expected return forecasts implied by the CAPM or APT is lower than the predictive regression strategy. However, with binding investment constraints, the performance of the APT matches that of the predictive regression.     

The Consumption/Wealth and Book/Market Ratios in a Dynamic Asset Pricing Contex

This paper addresses new insights into the predictability of financial returns. In particular, we analyze two aspects of the controversial forecasting literature. On the one hand, we demonstrate a positive and contemporaneous link between aggregate book/market and consumption/wealth ratios. On the other hand, we show that real estate and human capital, as the present value of all future salaries, are key components of the consumption/wealth ratio in Spain. Specifically, we find that the cointegrating residuals of consumption, asset holdings, real estate holdings, and our measure of human capital provide a better forecast of future returns than does the standard proxy of the consumption/wealth ratio. This result is important because it clarifies the importance of country-specific components of wealth for cases in which the consumption/wealth ratio is employed as an instrument in conditional asset pricing models.Belén Nieto: Financial support from the Ministerio de Ciencia y Tecnología grant SEJ2005-09372 is gratefully acknowledged.Rosa Rodríguez: Financial support from the Ministerio de Ciencia y Tecnología grant SEC2003-06457 is gratefully acknowledged.     

Cumulant instrument estimators for hedge fund return models with errors in variables

We revisit the factors incorporated in asset pricing models following the recent developments in financial markets – i.e., the rise of shadow banking and the change in the transmission channel of monetary policy. We propose two versions of the Fung and Hsieh (2004) hedge fund return model, especially an augmented market model which accounts for the new dynamics of financial markets and the procyclicality of hedge fund returns. We run these models with an innovative Hausman procedure, tackling the measurement errors embedded in the models factor loadings. Our empirical method also allows for confronting the drawbacks of the instruments used to estimate hedge fund asset pricing models.     

Rational functions: an alternative approach to asset pricing

This paper shows that asset prices are linear polynomials of various underlying explanatory factors and asset returns being ratios of these polynomials, are rational functions that do not add linearly when averaging. Hence, average returns should be modeled based on stock prices. However, continuous returns may be treated as approximately linear across time and modeled directly. Our new Rational Function (RF) models, empirically outperform the traditional asset pricing models like the Capital Asset Pricing Model (CAPM) and the Fama–French three and five-factor models for both average and continuous returns. Moreover, the RF theory also provides a model to estimate the asset volumes. The average change in asset volumes together with average returns provide the estimates for average change in market values of assets. Thus, the RF model approach can be used to select assets that provide either highest returns for profit maximization or highest change in market values for wealth maximization for given levels of risk.     

Can consumption-based asset pricing models using monetary conditioning variables explain the cross-section of German stock returns?

In this article, we analyse whether simple Consumption-based Capital Asset Pricing Models (CCAPMs) using monetary conditioning information (growth of the money aggregates M1, M2 and M3) can explain the cross-section of German size, book-to-market and industry portfolio returns. Our results show that models having stochastic discount factor parameters that vary with money aggregates can reduce the pricing errors of models with constant parameters. However, a large proportion of the cross-sectional variation remains unexplained.     

资产的理性定价模型和非理性定价模型的比较研究--基于中国股市的实证分析

本文以 1 995年 2月— 2 0 0 2年 6月深沪两市A股上市公司为样本 ,考察和对比三个定价模型———CAPM、三因素模型和特征模型。实证研究发现 :(1 )中国股市存在显著的“账面市值比效应”(BMEffect)和“规模效应”(SIZEEffect) ,但对于小公司则不存在“1月份效应” ;(2 )三因素模型比CAPM能更好地描述股票横截面收益的变化 ;(3 )基于“股票横截面收益是由公司特征决定”的非理性定价理论的特征模型不成立 ,而基于“股票横截面收益是由风险因素决定”的理性定价理论的三因素模型成立。这些发现说明 ,账面市值比和公司规模这二个变量代表的是一种“风险因素” ,并非“特征因素” ,因此中国股票横截面收益的变化取决于风险因素 ,而非特征因素。作者认为 ,导致上述结果的主要原因是中国股市长期的同涨同跌特征。     

Exploring consumption-based asset pricing model with stochastic-trend forcing processes

Using Canadian data, the consumption-based asset pricing model is studied, defined in terms of nondurable and durable goods consumption. A two-stage estimation procedure is used, which takes account of the presence of common stochastic trends in the forcing processes. This method yields more reasonable estimates of the preference parameters than the previous studies did, and the asset-pricing equation is not rejected by the data. Moreover, the preference specification adopted in this paper allows a number of useful economic information to be obtained. The additive separability assumption and the Cobb–Douglas functional form of the utility function are ruled complements in the sense of Edgeworth and Pareto.     

Drivers of expected returns in Istanbul stock exchange: Fama–French factors and coskewness

We investigate the impact of coskewness on the variation of portfolio excess returns in Istanbul Stock Exchange (ISE) over the period July 1999 to December 2005. We form portfolios according to size, industry, size and book-to-market ratio, momentum and coskewness and compare alternative asset pricing models. The traditional capital asset pricing model (CAPM) and the three-factor model of Fama and French are tested in the multivariate testing procedure of Gibbons–Ross–Shanken (1989). Coskewness is introduced as a fourth factor and its incremental effect over CAPM and Fama–French factors is examined both in multivariate tests and in cross-sectional regressions. The findings reveal that coskewness is able to explain the size premium in ISE. Hence, the basic two-moment CAPM without the coskewness factor would underestimate the expected return of size portfolios. Multivariate test results indicate that coskewness reduces the pricing bias, albeit insignificantly. Cross-sectional analysis uncovers that coskewness has a significant additional explanatory power over CAPM, especially for size and industry portfolios. However, coskewness does not have a significant incremental explanatory power over Fama–French factors in ISE.     

Asset pricing with adaptive learning

We study the extent to which self-referential adaptive learning can explain stylized asset pricing facts in a general equilibrium framework. In particular, we analyze the effects of recursive least squares and constant gain algorithms in a production economy and a Lucas type endowment economy. We find that (a) recursive least squares learning has almost no effects on asset price behavior, since the algorithm converges relatively fast to rational expectations, (b) constant gain learning may contribute towards explaining the stock price and return volatility as well as the predictability of excess returns in the endowment economy but (c) in the production economy the effects of constant gain learning are mitigated by the persistence induced by capital accumulation. We conclude that in the context of these two commonly used models, standard linear self-referential learning does not resolve the asset pricing puzzles observed in the data.