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Euler Equation Errors

  • Sydney C. Ludvigson

    ()

    (Economics New York University)

  • Martin Lettau

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 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. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Martin Lettau & Sydney C. Ludvigson, 2005. "Euler Equation Errors," NBER Working Papers 11606, National Bureau of Economic Research, Inc.
  3. Gallant, Ronald & Tauchen, George, 1989. "Seminonparametric Estimation of Conditionally Constrained Heterogeneous Processes: Asset Pricing Applications," Econometrica, Econometric Society, vol. 57(5), pages 1091-1120, September.
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  6. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
  7. 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.
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  13. Stephen Gordon & Pascal St-Amour, 2003. "Asset Returns and State-Dependent Risk Preferences," CIRANO Working Papers 2003s-09, CIRANO.
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  17. 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.
  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. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  20. 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.
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  22. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 1-47, February.
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