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Euler Equation Errors

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Author Info

  • Martin Lettau

    (University of California, Berkeley)

  • Sydney Ludvigson

    (New York University)

Abstract

The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross-sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data. (Copyright: Elsevier)

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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 12 (2009)
Issue (Month): 2 (April)
Pages: 255-283

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Handle: RePEc:red:issued:08-106

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Related research

Keywords: Equity premium puzzle; Euler equation; Pricing errors; Recessions;

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References

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Citations

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Cited by:
  1. Saziye Gaziog-super-˜lu & Azize Bastıyalı-Hayfavi, 2010. "Stochastic optimization applied to self-financing portfolio: does bequest matter?," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 42(30), pages 3831-3838.
  2. Lettau, Martin & Ludvigson, Sydney, 2005. "Euler Equation Errors," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5245, C.E.P.R. Discussion Papers.
  3. George M. Constantinides & Anisha Ghosh, 2008. "Asset Pricing Tests with Long Run Risks in Consumption Growth," NBER Working Papers 14543, National Bureau of Economic Research, Inc.
  4. Howitt, Peter, 2012. "What have central bankers learned from modern macroeconomic theory?," Journal of Macroeconomics, Elsevier, Elsevier, vol. 34(1), pages 11-22.
  5. Ravi Bansal & A. Ronald Gallant & George Tauchen, 2007. "Rational Pessimism, Rational Exuberance, and Asset Pricing Models," NBER Working Papers 13107, National Bureau of Economic Research, Inc.
  6. Raghu Suryanarayanan, 2006. "Implications of Anticipated Regret and Endogenous Beliefs for Equilibrium Asset Prices: A Theoretical Framework," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 162, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  7. Sydney Ludvigson, 2008. "The Research Agenda: Sydney Ludvigson on Empirical Evaluation of Economic Theories of Risk Premia," EconomicDynamics Newsletter, Review of Economic Dynamics, Review of Economic Dynamics, vol. 9(2), April.

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