Asset Pricing with Idiosyncratic Consumption Risk and Limited Participation

Abstract

A growing body of literature suggests limited asset market participation as a plausible explanation of the empirical failure of the standard consumption capital asset pricing model (CCAPM). Correct identification of capital markets investors is, however, often impossible due to imperfection of available information on assetholding status. As a plausible solution to the problem of sample classification when available information is an imperfect sample separation indicator, we propose the CCAPM in which the pricing kernel is calculated as the weighted average of individual households¡¯ marginal rate of substitution, with the weights being the probabilities of holding the asset in question. The asset holding probabilities are conditional on available sample separation information and estimated from a binary response model as a function of demographic and family characteristics of consumers simultaneously with the parameters of Euler equations. The CCAPM with probability-weighted agents is less susceptible to sample misclassification compared to when available imperfect information on asset holding status is used to separate assetholders from nonassetholders. Using data from the U.S. Consumer Expenditure Survey (CEX), we find that, in contrast to when the reported in the CEX financial information is regarded as a perfect sample separation indicator, the model with probability-weighted agents is not rejected statistically both under conventional normal and weak-identification asymptotics and yields precise and economically realistic estimates of the coefficient of relative risk aversion (RRA). The hypothesis that the households¡¯ market participation behavior exhibits considerable persistence is not rejected statistically. Empirical evidence is that the decision to own assets is likely to be endogenous with respect to the consumption and savings decisions and that allowing for this fact is important for estimating risk aversion.equity premium puzzle, Euler equation, limited asset market participation, probit model, risk-free rate puzzle