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Euler Equation Errors

  • Sydney C. Ludvigson

    ()

    (Economics New York University)

  • Martin Lettau

The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross- sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

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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. 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. 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.
  3. Gallant, A.R. & Tauchen, G., 1988. "Seminonparametric Estimation Of Conditionally Constrained Heterogeneous Processes: Asset Pricing Applications," Papers 88-59, Chicago - Graduate School of Business.
  4. 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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  7. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  8. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  9. Sydney Ludvigson, 1996. "Consumption and credit: a model of time-varying liquidity constraints," Research Paper 9624, Federal Reserve Bank of New York.
  10. 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. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June.
  18. Cogley, Timothy & Sargent, Thomas J., 2008. "The market price of risk and the equity premium: A legacy of the Great Depression?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 454-476, April.
  19. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, vol. 64(6), pages 1439-67, November.
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  23. 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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