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Euler Equation Errors

Author

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  • Sydney C. Ludvigson

    () (Economics New York University)

  • Martin Lettau

Abstract

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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Suggested Citation

  • Sydney C. Ludvigson & Martin Lettau, 2005. "Euler Equation Errors," 2005 Meeting Papers 487, Society for Economic Dynamics.
  • Handle: RePEc:red:sed005:487
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    References listed on IDEAS

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    Cited by:

    1. Gomes, Fábio Augusto Reis & Ribeiro, Priscila Fernandes, 2015. "Estimating the elasticity of intertemporal substitution taking into account the precautionary savings motive," Journal of Macroeconomics, Elsevier, vol. 45(C), pages 108-123.
    2. Drew Creal & Siem Jan Koopman & André Lucas & Marcin Zamojski, 2015. "Generalized Autoregressive Method of Moments," Tinbergen Institute Discussion Papers 15-138/III, Tinbergen Institute.
    3. Bjørn Eraker, 2008. "Affine General Equilibrium Models," Management Science, INFORMS, vol. 54(12), pages 2068-2080, December.
    4. repec:eee:reveco:v:51:y:2017:i:c:p:157-173 is not listed on IDEAS
    5. George M. Constantinides & Anisha Ghosh, 2011. "Asset Pricing Tests with Long-run Risks in Consumption Growth," Review of Asset Pricing Studies, Oxford University Press, vol. 1(1), pages 96-136.
    6. Bansal, Ravi & Kiku, Dana & Yaron, Amir, 2016. "Risks for the long run: Estimation with time aggregation," Journal of Monetary Economics, Elsevier, vol. 82(C), pages 52-69.
    7. Raghu Suryanarayanan, 2006. "Implications of Anticipated Regret and Endogenous Beliefs for Equilibrium Asset Prices: A Theoretical Framework," CSEF Working Papers 162, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    8. 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.
    9. Ravi Bansal & A. Ronald Gallant & George Tauchen, 2007. "Rational Pessimism, Rational Exuberance, and Asset Pricing Models," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1005-1033.
    10. Sydney Ludvigson, 2008. "The Research Agenda: Sydney Ludvigson on Empirical Evaluation of Economic Theories of Risk Premia," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 9(2), April.
    11. Howitt, Peter, 2012. "What have central bankers learned from modern macroeconomic theory?," Journal of Macroeconomics, Elsevier, vol. 34(1), pages 11-22.
    12. Ludvigson, Sydney C., 2013. "Advances in Consumption-Based Asset Pricing: Empirical Tests," Handbook of the Economics of Finance, Elsevier.
    13. Saziye Gaziog-super-˜lu & Azize Bastıyalı-Hayfavi, 2010. "Stochastic optimization applied to self-financing portfolio: does bequest matter?," Applied Economics, Taylor & Francis Journals, vol. 42(30), pages 3831-3838.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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