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Evaluating Consumption CAPM under Heterogeneous Preferences

Author

Listed:
  • Berg Cui

    (Indiana University)

  • Yoosoon Chang

    (Indiana University)

  • Joon Park

    (Indiana University)

Abstract

We construct Consumption CAPM pricing kernel under heterogeneous Epstein-Zin-Weil (EZW) preferences setup. We show except under some strict assumptions,aggregation does not hold and individual level information is necessary to price assets. Assuming complete market, we estimate preferences parameters for heterogeneous agents using households level consumption and wealth data from Panel Study of Income Dynamics (PSID) database. Contrast to the literature, we get relatively larger Elasticity of Inter-temporal Substitution (EIS) and much smaller Relative Risk Aversion (RRA) parameters. We then calculate excess return for risky assets using Consumption-CAPM pricing kernel with our estimated preferences and individual consumption and wealth data. We show that our heterogeneous perferences pricing kernel improves the representative agent pricing kernel at three fronts, namely idiosyncratic risk factors, heterogeneous factor premia and idiosyncratic characteristics dependent aggregation weights. Each front improves the explanatory power to real world risk premium and cross sectional differences in stock excess returns. Lastly, we demonstrate another advantage of heterogeneous preferences model in terms of accounting for market participation heterogeneity. Including market participants only further improves model's explanatory power on market risk premium dynamics.

Suggested Citation

  • Berg Cui & Yoosoon Chang & Joon Park, 2017. "Evaluating Consumption CAPM under Heterogeneous Preferences," CAEPR Working Papers 2017-013, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
    • Handle: RePEc:inu:caeprp:2017013
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    References listed on IDEAS

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    More about this item

    Keywords

    Consumption CAPM; Epstein-Zin-Weil; heterogeneous preferences; heterogeneous market participation;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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