Institution-Based Asset Pricing: A Generalization of Consumption- and Production-Based Models

Standard asset pricing models, whether consumption-based (CCAPM) or production-based (PCAPM), treat institutions-such as property rights, contract enforcement, and rule of law-as exogenous, stable, and frictionless. This assumption collapses under empirical scrutiny in a world where institutional deterioration, geopolitical conflict, and strategic coercion shape both economic fundamentals and financial markets. We develop a new framework of Institution- Based Asset Pricing (IBAP) in which institutions are modeled as a dynamic, investable capital stock. Agents optimally allocate resources not only to con sumption and physical capital, but also to institutional investment, which sustains enforcement mechanisms and mitigates systemic risk. Institutional quality enters both the production function and the utility function, directly affecting the stochastic discount factor and asset risk premia. Our model explains fundamental differences in asset pricing mechanisms across political regimes for instance, between China's extractive, state-controlled financial system and the liberal, rules-based system of the United States. We show that shocks to institutional depreciation, underinvestment, or coercive disruption (e.g., rare earth embargoes, chip sanctions, or capital controls) propagate into asset prices, volatility, and returns. By endogenizing institutions, this paper offers a unified theory of growth, risk, and valuation under institutional uncertainty -- one that is urgently needed in today’s multipolar and unstable global order.