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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 cross-sections of asset returns. Here we ask whether calibrated leading asset pricing models - specifically developed to address empirical puzzles associated with the standard paradigm - explain the mispricing of the standard consumption-based model when evaluated on cross-sections of asset returns. 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, such a kernel will not rationalize the magnitude of the pricing errors generated by the standard model, particularly when the curvature of utility is high. Second, we show that leading asset pricing models also do not explain the significant mispricing of the standard paradigm for plausibly calibrated sets of asset returns, 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 one example of a limited participation/incomplete markets model capable of explaining larger pricing errors for the standard model; but we also find many examples of such models, in which the consumption of marginal assetholders behaves quite differently from per capita aggregate consumption, that do not explain the large Euler equation errors of the standard representative agent model.

(This abstract was borrowed from another version of this item.)

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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. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  2. Sydney Ludvigson, 1996. "Consumption and credit: a model of time-varying liquidity constraints," Research Paper 9624, Federal Reserve Bank of New York.
  3. Cogley, Timothy W. & Sargent, Thomas J., 2005. "The Market Price of Risk and the Equity Premium," Working Papers 05-22, University of California at Davis, Department of Economics.
  4. M. Fatih Guvenen, 2003. "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-sectional Heterogeneity?," RCER Working Papers 499, University of Rochester - Center for Economic Research (RCER).
  5. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
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  7. Gallant, A.R. & Tauchen, G., 1988. "Seminonparametric Estimation Of Conditionally Constrained Heterogeneous Processes: Asset Pricing Applications," Papers 88-59, Chicago - Graduate School of Business.
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  11. Hui Guo, 2003. "Limited stock market participation and asset prices in a dynamic economy," Working Papers 2000-031, Federal Reserve Bank of St. Louis.
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  14. Ravi Jagannathan & Yong Wang, 2005. "Consumption Risk and the Cost of Equity Capital," NBER Working Papers 11026, National Bureau of Economic Research, Inc.
  15. 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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  17. Martin Lettau & Sydney Ludvigson, 2009. "Euler Equation Errors," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(2), pages 255-283, April.
  18. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  19. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887 Elsevier.
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Cited by:
  1. 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.
  2. Anisha Ghosh & George Constantinides, 2008. "Asset Pricing Tests with Long Run Risks in Consumption Growth," FMG Discussion Papers dp609, Financial Markets Group.
  3. Lettau, Martin & Ludvigson, Sydney, 2005. "Euler Equation Errors," CEPR Discussion Papers 5245, C.E.P.R. Discussion Papers.
  4. 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.
  5. 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.

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