Consumption Risk and Expected Stock Returns

Following the textbook C-CAPM, the consumption risk of an asset is typically measured as the contemporaneous covariance of the marginal utility of consumption and the return on that asset. When measured this way, consumption risk is too small to explain the observed equity premium, is negatively related to expected excess returns over time, and fails to explain the cross-sectional differences in average returns of the Fama and French (25) portfolios. This paper evaluates the central insight of the C-CAPM - that consumption risk determines returns - but take the model less literally by allowing the possibility that households do not instantaneously and completely adjust consumption to the news revealed about wealth in a period. The long-term consumption risk of the aggregate market is signficantly larger than the contemporaneous risk and is positively related to expected excess returns over time. The long-term consumption risk of different portfolios largely explains the observed differences in average returns.

Spendthrift in America? On Two Decades of Decline in the U.S. Saving Rate

During the past two decades, the personal saving rate in the United States has fallen from eight percent to below zero. This paper demonstrates that this change represents a major shift in the allocation of newly produced goods. The share of GDP that households consume rose by 6 percentage points since 1980. This increase occurred concurrently with a reduction in the growth rate of real consumption spending per person, high real rates of return, and an increasing ratio of aggregate wealth to income. Despite this last fact, wealth changes can explain little of the boom in consumption spending. The largest increases in national wealth post-date the consumption boom and households with different wealth levels have similar increases in consumption. The paper also finds that the changing age distribution of the U.S. population does not explain the consumption boom. While it may be that new wealthier cohorts are driving this boom, the preponderance of evidence suggest rather that the rising consumption to income ratio is due to a common time effect. The main findings of the paper are consistent with either an increase in the discount rate or with a general belief in better economic times in the future. Alternatively, the low rates of saving could be due to a combination of factors such as the increase in intergenerational transfers from the Social Security system raising the consumption of the elderly and an increase in access to credit and expanded financial instruments raising the consumption of the young.

Consumption Risk And Expected Stock Returns

Following the textbook CCAPM, the consumption risk of an asset is typically measured as the contemporaneous covariance of the marginal utility of consumption and the return on that asset. When measured this way, consumption risk is too small to explain the observed equity premium, is negatively related to expected excess returns over time, and fails to explain the cross-sectional differences in average returns of the Fama and French (25) portfolios. This paper evaluates the central insight of the CCAPM — that consumption risk determines returns — but take the model less literally by allowing the possibility that households do not instantaneously and completely adjust consumption to the news revealed about wealth in a period. The long-term consumption risk of the aggregate market is signficantly larger than the contemporaneous risk and is positively related to expected excess returns over time. The long-term consumption risk of different portfolios largely explains the observed differences in average returns.Consumption Capital Asset Pricing Model, Expected returns, Equity premium, Consumption risk, Consumption smoothing

Consumption Risk and the Cross-Section of Expected Returns

This paper evaluates the central insight of the Consumption Capital Asset Pricing Model (CCAPM) that an asset’s expected return is determined by its equilibrium risk to consumption. Rather than measure the risk of a portfolio by the contemporaneous covariance of its return and consumption growth — as done in the previous literature on the CCAPM and the pattern of crosssectional returns — we measure the risk of a portfolio by its ultimate consumption risk defined as the covariance of its return and consumption growth over the quarter of the return and many following quarters. While contemporaneous consumption risk explains little of the variation in observed average returns across the Fama and French 25 portfolios, ultimate consumption risk at a horizon of three years explains a large fraction of this variation.Consumption Capital Asset Pricing Model, Expected returns, Equity premium, Consumption risk, Consumption smoothing

Consumption Risk and Cross-Sectional Returns

This paper evaluates the central insight of the Consumption Capital Asset Pricing Model (C-CAPM) that an asset's expected return is determined by its equilibrium risk to consumption. Rather that measure the risk of a portfolio by the contemporaneous covariance of its return and consumption growth -- as done in the previous literature on the C-CAPM and the pattern of cross-sectional returns -- we measure the risk of a portfolio by its ultimate consumption risk defined as the covariance of its return and consumption growth over the quarter of the return and many following quarters. While contemporaneous consumption risk has little predictive power for explaining the pattern of average returns across the Fama and French (25) portfolios, ultimate consumption risk is highly statistically significant in explaining average returns and explains a large fraction of the variation in average returns. Aditionally, estimates of the average risk-free real rate of interest and the coefficient of relative risk aversion of the representative household based on ultimate consumption risk are more reasonable than those obtained using contemporaneous consumption risk.

Precautionary Saving and Consumption Fluctuations

This paper uses the consumption Euler equation to derive a decomposition of consumption growth into four sources. These are new information and three sources of predictable consumption growth: intertemporal substitution, changes in the preferences for consumption, and incomplete markets for consumption in- surance. Using data on the expenditures of households, we implement the decom- position for the average growth rate of consumption expenditures on nondurable goods in the U.S. from the beginning of 1982 to the end of 1997. Incomplete markets for trading consumption in future states lead to statistically signiÞcant and countercyclical movements in expected consumption growth: consumption growth is expected to be higher when the unemployment rate is high. The eco- nomic importance of precautionary saving rivals that of the real interest rate, but the relative importance of each source of movement in the volatility of consump- tion is not precisely measured.

Taxes and Growth in a Financially Underdeveloped Country: Evidence from the Chilean Investment Boom

This paper argues that taxation of retained profits is particularly distortionary in an economy with good growth prospects and poorly developed financial markets because it primarily reduces the investment of financially constrained firms, investment that has marginal product greater than the after-tax market real interest rate. Contrarily, taxes on distributed profits or capital gains primarily reduce the investment of financially unconstrained firms. Chile experienced a banking crisis over the period from 1982 to 1986 and in 1984 reduced its tax rate on retained profits from 50 percent to 10 percent. We show that, consistent with our theory, there was a large increase in aggregate investment after the reform which was entirely funded by an increase in retained profits. Further, we show that investment grew by more in industries that depend more on external financing, according to the Rajan and Zingales (1998) measure. Finally, we present some weak evidence from comparisons of investment rates across firms for several different measures of their likelihood of being financially constrained.

Optimal Expectations

This paper introduces a tractable, structural model of subjective beliefs. Since agents that plan for the future care about expected future utility flows, current felicity can be increased by believing that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decision making, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the total well-being of an agent over time. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return of their investment and under diversify. In general equilibrium, agents’ prior beliefs are endogenously heterogeneous, leading to gambling. Second, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life. Third, in choosing when to undertake a single task with an uncertain cost, agents exhibit several features of procrastination, including regret, intertemporal preference, reversal, and a greater readiness to accept commitment.Expectations formation, beliefs, overconfidence, wishful thinking, procrastination, gambling