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The Wealth-Consumption Ratio: A Litmus Test for Consumption-based Asset Pricing Models¤

Listed author(s):
  • Hanno Lustig

    ()

    (UCLA and NBER)

  • Stijn Van Nieuwerburg

    ()

    (NYU and NBER)

  • Adrien Verdelhan

    ()

    (Boston University)

The volatility of the price-dividend ratio on stocks, the predictability of stock returns, and the lack of predictability in dividend growth are commonly interpreted as evidence of substantial time-variation in risk premia. We construct the wealth-consumption ratio for the U.S., the price-dividend ratio on total wealth. We show that it is at least ¯ve times less volatile than the price-dividend ratio on stocks. The wealth-consumption ratio encodes information about conditional market prices of risk, and hence about asset prices. Matching its properties is a litmus test for consumption-based asset pricing models. Models that match the predictability of equity returns impute too much predictability to total wealth returns and hence too much volatility to the wealth-consumption ratio, because they rely on time variation in the risk premium on total wealth. The smoothness of the wealth-consumption ratio suggests that there may be less time-variation in market prices of risk than commonly inferred from equity prices alone.

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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number WP2007-030.

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Length: 71pages
Date of creation: Apr 2007
Handle: RePEc:bos:wpaper:wp2007-030
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