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Euler Equation Errors

  • Lettau, Martin
  • Ludvigson, Sydney

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4922.

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Date of creation: Feb 2005
Date of revision:
Handle: RePEc:cpr:ceprdp:4922
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  1. Tim W. Cogley & Thomas J. Sargent, 2005. "The Market Price of Risk and the Equity Premium," Working Papers 522, University of California, Davis, Department of Economics.
  2. Sydney C. Ludvigson & Martin Lettau, 2005. "Euler Equation Errors," 2005 Meeting Papers 487, Society for Economic Dynamics.
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  17. Fatih Guvenen, 2005. "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation of Cross-sectional Heterogeneity?," Finance 0507009, EconWPA.
  18. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  19. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  20. 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.
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