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Explaining the Poor Performance of Consumption-Based Asset Pricing Models

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  • John Y. Campbell
  • John H. Cochrane

Abstract

The poor performance of consumption-based asset pricing models relative to traditional portfolio-based asset pricing models is one of the great disappointments of the empirical asset pricing literature. We show that the external habit-formation model economy of Campbell and Cochrane (1999) can explain this puzzle. Though artificial data from that economy conform to a consumption-based model by construction, the CAPM and its extensions are much better approximate models than is the standard power utility specification of the consumption-based model. Conditioning information is the central reason for this result. The model economy has one shock, so when returns are measured at sufficiently high frequency the consumption-based model and the CAPM are equivalent and perfect conditional asset pricing models. However, the model economy also produces time-varying expected returns, tracked by the dividend-price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture, and so portfolio-based models are better approximate unconditional asset pricing models.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7237.

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Date of creation: Jul 1999
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Publication status: published as Campbell, John Y. and John H. Cochrane. "Explaining The Poor Performance Of Consumption-Based Asset Pricing Models," Journal of Finance, 2000, v55(6,Dec), 2863-2878.
Handle: RePEc:nbr:nberwo:7237

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  1. Andrew B. Abel, 1990. "Asset Prices under Habit Formation and Catching up with the Joneses," NBER Working Papers 3279, National Bureau of Economic Research, Inc.
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