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Euler Equation Errors

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  • Sydney C. Ludvigson

    ()
    (Economics New York University)

  • Martin Lettau

Abstract

Among the most important pieces of empirical evidence against the standard representative-agent, consumption-based asset pricing paradigm are the formidable unconditional Euler equation errors the model produces for a broad stock market index return and short-term interest rate. Unconditional Euler equation errors are also large for a broader cross-section of returns. Here we ask whether calibrated leading asset pricing models – specifically developed to address empirical puzzles associated with the standard paradigm – explain these empirical facts. We find that, in many cases, they do not. We present several results. First, we show that if the true pricing kernel that sets the unconditional Euler equation errors to zero is jointly lognormally distributed with aggregate consumption and returns, then values for the subjective discount factor and relative risk aversion can always be found for which the standard model generates identical unconditional asset pricing implications for two asset returns, a risky and risk-free asset. Second, we show, using simulated data from several leading asset pricing frameworks, that many economic models share this property even though in those models the pricing kernel, returns, and consumption are not jointly lognormally distributed. Third, in contrast to the above results, we provide an example of a limited participation/incomplete markets model that is broadly consistent with these empirical facts.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 487.

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Date of creation: 2005
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Handle: RePEc:red:sed005:487

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  1. Gallant, Ronald & Tauchen, George, 1989. "Seminonparametric Estimation of Conditionally Constrained Heterogeneous Processes: Asset Pricing Applications," Econometrica, Econometric Society, vol. 57(5), pages 1091-1120, September.
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  7. Fatih Guvenen, 2005. "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation of Cross-sectional Heterogeneity?," Finance 0507009, EconWPA.
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  12. Sydney Ludvigson, 1996. "Consumption and credit: a model of time-varying liquidity constraints," Research Paper 9624, Federal Reserve Bank of New York.
  13. Ravi Jagannathan & Yong Wang, 2005. "Consumption Risk and the Cost of Equity Capital," NBER Working Papers 11026, National Bureau of Economic Research, Inc.
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  15. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  16. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Working Papers melino-03-01, University of Toronto, Department of Economics.
  17. Guo, Hui, 2004. "Limited Stock Market Participation and Asset Prices in a Dynamic Economy," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(03), pages 495-516, September.
  18. John Y. Campbell, 2002. "Consumption-Based Asset Pricing," Harvard Institute of Economic Research Working Papers 1974, Harvard - Institute of Economic Research.
  19. Lettau, Martin & Ludvigson, Sydney, 2002. "Expected Returns and Expected Dividend Growth," CEPR Discussion Papers 3507, C.E.P.R. Discussion Papers.
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Cited by:
  1. Lettau, Martin & Ludvigson, Sydney, 2005. "Euler Equation Errors," CEPR Discussion Papers 5245, C.E.P.R. Discussion Papers.
  2. Raghu Suryanarayanan, 2006. "Implications of Anticipated Regret and Endogenous Beliefs for Equilibrium Asset Prices: A Theoretical Framework," CSEF Working Papers 162, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  3. 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.
  4. Howitt, Peter, 2012. "What have central bankers learned from modern macroeconomic theory?," Journal of Macroeconomics, Elsevier, vol. 34(1), pages 11-22.
  5. Anisha Ghosh & George Constantinides, 2008. "Asset Pricing Tests with Long Run Risks in Consumption Growth," FMG Discussion Papers dp609, Financial Markets Group.
  6. Saziye Gaziog-super-˜lu & Azize Bastıyalı-Hayfavi, 2010. "Stochastic optimization applied to self-financing portfolio: does bequest matter?," Applied Economics, Taylor & Francis Journals, vol. 42(30), pages 3831-3838.
  7. Sydney Ludvigson, 2008. "The Research Agenda: Sydney Ludvigson on Empirical Evaluation of Economic Theories of Risk Premia," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 9(2), April.

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