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Consumption Risk and the Cost of Equity Capital

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  • Ravi Jagannathan
  • Yong Wang

Abstract

We demonstrate, using data for the period 1954-2003, that differences in exposure to consumption risk explains cross sectional differences in average excess returns (cost of equity capital) across the 25 benchmark equity portfolios constructed by Fama and French (1993). We use yearly returns on stocks to take into account well documented within year deterministic seasonal patterns in returns, measurement errors in the consumption data, and possible slow adjustment of consumption to changes in wealth due to habit and prior commitments. Consumption during the fourth quarter is likely to have a larger discretionary component. Further, given the availability of more leisure time during the holiday season and the ending of the tax year in December, investors are more likely to review their asset holdings and make trading decisions during the fourth quarter. We therefore match the growth rate in the fourth quarter consumption from one year to the next with the corresponding calendar year return when computing the latter's exposure to consumption risk. We find strong support for our consumption risk model specification in the data.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11026.

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Date of creation: Jan 2005
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Publication status: Forthcoming in the August 2007 issue of the Journal of Finance under the title, "Lazy Investors, Discretionary Consumption, and the Cross Section of Stock Returns."
Handle: RePEc:nbr:nberwo:11026

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Cited by:
  1. Hanno Lustig & Adrien Verdelhan, 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2006-045, Boston University - Department of Economics.
  2. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  3. Martin Lettau & Sydney C. Ludvigson, 2005. "Euler Equation Errors," NBER Working Papers 11606, National Bureau of Economic Research, Inc.
  4. Magdalena Morgese Borys, 2007. "Testing Multi-Factor Asset Pricing Models in the Visegrad Countries," CERGE-EI Working Papers wp323, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  5. John Cochrane, 2005. "Financial Markets and the Real Economy," NBER Working Papers 11193, National Bureau of Economic Research, Inc.
  6. Adam Szeidl & Raj Chetty, 2005. "Consumption Commitments: Neoclassical Foundations for Habit Formation," 2005 Meeting Papers 122, Society for Economic Dynamics.

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