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Using Long-Run Consumption-Return Correlations to Test Asset Pricing Models

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  • Jianfeng Yu

    (University of Minnesota)

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    Abstract

    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. (Copyright: Elsevier)

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    File URL: http://dx.doi.org/10.1016/j.red.2012.04.001
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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): 15 (2012)
    Issue (Month): 3 (October)
    Pages: 317-335

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    Handle: RePEc:red:issued:10-230

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    Keywords: Long-run risk; Forward-looking;

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    References

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    1. Hanno Lustig & Stijn Van Nieuwerburgh & Adrien Verdelhan, 2008. "The Wealth-Consumption Ratio," NBER Working Papers 13896, National Bureau of Economic Research, Inc.
    2. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
    3. Otrok, C. & Ravikumar, B. & Whiteman, C., 1998. "Habit Formation: A Resolution of the Equity Premium Puzzle?," Working Papers, University of Iowa, Department of Economics 98-04, University of Iowa, Department of Economics.
    4. James C. Morley & Charles R. Nelson & Eric Zivot, 2003. "Why Are the Beveridge-Nelson and Unobserved-Components Decompositions of GDP So Different?," The Review of Economics and Statistics, MIT Press, vol. 85(2), pages 235-243, May.
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    6. 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.
    7. Jessica A. Wachter, 2005. "Solving Models with External Habit," NBER Working Papers 11559, National Bureau of Economic Research, Inc.
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    11. Jonathan A. Parker & Christian Julliard, 2004. "Consumption Risk and the Cross-Section of Expected Returns," Working Papers, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics. 138, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
    12. Ilan Cooper, 2009. "Time-Varying Risk Premiums and the Output Gap," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(7), pages 2601-2633, July.
    13. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, Elsevier, vol. 79(2), pages 365-399, February.
    14. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, American Finance Association, vol. 59(4), pages 1481-1509, 08.
    15. Fernando Alvarez & Urban J. Jermann, 2005. "Using Asset Prices to Measure the Persistence of the Marginal Utility of Wealth," Econometrica, Econometric Society, Econometric Society, vol. 73(6), pages 1977-2016, November.
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    17. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, Econometric Society, vol. 57(4), pages 937-69, July.
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    Cited by:
    1. Victoria Atanasov, 2014. "Common Risk Factors in Equity Markets," Tinbergen Institute Discussion Papers, Tinbergen Institute 14-070/IV, Tinbergen Institute.

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