A class of models satisfying a dynamical version of the CAPM

Under a comonotonicity assumption between aggregate dividends and the market portfolio, the CCAPM formula becomes more tractable and more easily testable. In this paper, we provide theoretical justifications for such an assumption.CAPM, CCAPM, market beta, equilibrium, financial markets

Pricing model performance and the two-pass cross-sectional regression methodology

Since Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973), the two-pass cross-sectional regression (CSR) methodology has become the most popular approach for estimating and testing asset pricing models. Statistical inference with this method is typically conducted under the assumption that the models are correctly specified, that is, expected returns are exactly linear in asset betas. This assumption can be a problem in practice since all models are, at best, approximations of reality and are likely to be subject to a certain degree of misspecification. We propose a general methodology for computing misspecification-robust asymptotic standard errors of the risk premia estimates. We also derive the asymptotic distribution of the sample CSR R2 and develop a test of whether two competing linear beta pricing models have the same population R2. This test provides a formal alternative to the common heuristic of simply comparing the R2 estimates in evaluating relative model performance. Finally, we provide an empirical application, which demonstrates the importance of our new results when applied to a variety of asset pricing models.Econometric models ; Asset pricing

The Risk Premium for Equity: Explanations and Implications

The equity premium puzzle shows that using standard parameters and setup, the Consumption-based Capital Asset Pricing Model's (CCAPM's) prediction of the premium associated with systematic risk is out by an order of magnitude.The object of this paper is to consider the implications of each of the broad classes of explanations of the equity premium puzzle for resource allocation, welfare and policy.We argue that the most robust implications are those that flow directly from the high price of systematic risk and are therefore independent of the resolution of the puzzle.risk premium;equity capital;resource allocation;welfare;capital asset pricing

The Risk Premium for Equity: Implicatiosn for Resource Allocation, Welfare adn Policy

Analysis of the equity premium puzzle has focused on private sector capital markets. The object of this paper is to consider the welfare and policy implications of each of the broad classes of explanations of the equity premium puzzle. As would be expected, the greater the deviation from the first-best outcome implied by a given explanation of the equity premium puzzle, the more interventionist are the implied policy conclusions. Nevertheless, even explanations of the equity premium puzzle consistent with a general consumption-based asset pricing model have important welfare and policy implications.

An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors

There are a number of tests and measures of the degree of integration in the literature. An example is the idea that integrated markets should provide rates of return that are highly correlated with one another and that a measure of correlation provides an appropriate test. This particular idea is clearly false; for substantial periods of time we don't ever see stocks traded on the same market moving together. Specific models of what prices risk in individual markets could provide the basis of a test of integration. However, as has been widely shown, any differences between these pricing models will be subject to arbitrage by informed traders and so cannot form the basis for a test. In this paper we exploit the absence of arbitrage possibilities and the operation of the 'Law of One Price' in stochastic discount factor (SDF) theory to construct a test of integration based on a common approach to pricing assets in all markets, not only for stocks. The SDF approach that we adopt says that one SDF should price all assets as the model is not market or asset-specific.Unlike much of the literature, we adopt a direct parametric approach which takes estimates of an identical SDF from two asset markets and asks whether the price of risk associated with this SDF is the same for the two assets as SDF theory says it should. Another distinctive feature of our approach is that we employ observable macroeconomic factors. This allows us to estimate and compare the estimated risk premia in the markets concerned, with and without the integration restriction being applied. The paper uses this methodology to test market integration between the UK equity and FOREX markets. Our test rejects market integration for the consumption-based capital asset pricing model (CCAPM) and two variable SDF models based on consumption growth and inflation and on output and money growth. As equity and FOREX returns have a similar degree of variability, the finding that the risk premium in the FOREX market is generally much more variable than that in the equity market may contribute to the the test outcome.

Money Market Rates and Implied CCAPM Rates: Some International Evidence

New Neoclassical Synthesis models equate the instrument of monetary policy to the implied CCAPM rate arising from an Euler equation. This paper identifies monetary policy shocks within six of the G7 countries and examines the movement of money market and implied CCAPM rates. The key result is that an increase in the nominal interest rate leads to a fall in the implied CCAPM rate. Incorporating habit still yields the same result. The findings suggest that the movement of these two rates implied by the transmission mechanism of monetary policy in NNS models cannot be reconciled through the consumption Euler equation.Consumption Euler equation, Monetary Policy Shocks, Transmission Mechanism.

Robust Aggregate Implications of Stochastic Discount Factor Volatility

The stochastic discount factor seems volatile, but is this observation of any consequence for aggregate analysis of consumption, capital accumulation, output, etc.? I amend the standard frictionless model of aggregate consumption and capital accumulation with time-varying subjective probability adjustments, and obtain four implications for aggregate economic analysis. First, subjective probability adjustments add volatility to the stochastic discount factor, and can rationalize any pattern of asset prices satisfying no-arbitrage, even while capital accumulation is efficient. Second, despite its flexibility in pricing assets, the model implies that, in expected value, the intertemporal marginal rate of transformation is equal to the intertemporal marginal rate of substitution, and there is a simple, stable, and familiar relation between consumption growth and capital's return. Third, the expected returns on assets in small net aggregate supply are weakly (and sometimes negatively) correlated with capital's expected return, and are thereby poor predictors of aggregate consumption growth. Fourth, when it comes to assets in small net aggregate supply, capital gains reflect time varying risk premia, and returns can predict aggregate consumption growth better when the capital gain component of those returns is ignored. All four implications are consistent with empirical results reported here, and in the previous literature documenting stochastic discount factor volatility. Several recent theories of stochastic discount factor volatility can, from the aggregate point of view, be interpreted as special cases of subjective probability adjusted CCAPM.

Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perpective

In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the US, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains eighty percent of the cross-sectional variation in annual size and book-to-market portfolio returns. A data appendix for this paper is available .

Consumption-Based Asset Pricing with a Reference Level: New Evidence from the Cross-Section of Stock Returns

This paper presents an empirical evaluation of recently proposed asset pricing models which extend the standard preference specification by a reference level of consumption. The novelty is that we use a broad cross-section of test assets, which provides a level playing field for a comparison to well-established benchmark models. We also motivate a specification that accounts for the return on human capital as a determinant of the reference level. We find that this extension does a good job in explaining the cross-sectional variation in average returns across the 25 Fama- French portfolios with pricing errors close to those of Lettau/Ludvigson's celebrated scaled factor models. --Consumption-based Asset Pricing,Cross-Section of Stock Returns,Reference Level