Explaining the Poor Performance of Consumption‐based Asset Pricing Models

By John Y. Campbell, John H. Cochrane. 2000

352 citations recorded by the source corpus.

We show that the external habit-formation model economy of Campbell and Cochrane ~1999! can explain why the Capital Asset Pricing Model ~CAPM! and its extensions are better approximate asset pricing models than is the standard consumptionbased model. The model economy produces time-varying expected returns, tracked by the dividend‐price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture. Therefore, though the consumption-based model and CAPM are both perfect conditional asset pricing models, the portfolio-based models are better approximate unconditional asset pricing models. THE DEVELOPMENT OF CONSUMPTION-BASED ASSET PRICING THEORY ranks as one of the major advances in financial economics during the last two decades. The classic papers of Lucas ~1978!, Breeden ~1979!, Grossman and Shiller ~1981!, and Hansen and Singleton ~1982, 1983! show how a simple relation between consumption and asset returns captures the implications of complex dynamic intertemporal multifactor asset pricing models. Unfortunately, consumption-based asset pricing models prove disappointing empirically. Hansen and Singleton ~1982, 1983! formulate a canonical consumption-based model in which a representative investor has timeseparable power utility of consumption. They reject the model on U.S. data, finding that it can not simultaneously explain the time-variation of interest rates and the cross-sectional pattern of average returns on stocks and bonds. Wheatley ~1988! rejects the model on international data. All models can be rejected, and the more important issue is which approximate models are most useful. Alas, the canonical consumption-based model performs no better, and in many respects worse, than even the simple static Capital Asset Pricing Model ~CAPM!. Mankiw and Shapiro ~1986! regress the average returns of the 464 NYSE stocks that were continuously traded from 1959 to 1982 on their market betas, on consumption growth betas, and on both betas. They find that market betas are more strongly and robustly

Subfields: Accounting, Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/ccc226545759e0c6c915920abd3d6d8ebe54f389

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Citations in the corpus

Heterogeneous Beliefs, Speculation, and the Equity Premium (2008, background): “If the quantities on the right hand side are time-varying (as is implied by Lemma 2) then care has to be 32 taken to extend the implications of this pricing equation to its unconditional form (see Hansen and Richard 1987, Campbell and Cochrane 2000).”
Presidential Address: Discount Rates (2011, background): “For example, suppose investors have “equity” and “debt” 36 Campbell and Cochrane (2000) give a quantitative example.”
Idiosyncratic Consumption Risk and the Cross-Section of Asset Returns (2004, neutral): “Campbell and Cochrane (2000) provide an explanation for why consumption-based asset pricing models perform better conditionally than unconditionally.”
Home Bias in International Equity Portfolios: A Review (2007, neutral): “V (w t , st) = max cjt ,x j t [(cjt ) (1−θ) + βEt(V (w j t+1, st+1) 1−γ)(1−θ)/(1−γ)] 1 1−θ (14)”
Does risk aversion drive financial crises? Testing the predictive power of empirical indicators (2008, background): “However, the CCAPM theoretical model is still not discredited since these poor empirical findings may come from specifications on the utility function or on the parameters (Campbell and Cochrane, 2000).”
Corporate Real Estate Holdings and the Cross-Section of Stock Returns (2010, neutral): “Since there is a single aggregate shock in the model, return on the market portfolio and the pricing kernel become instantaneously perfectly (negatively) correlated (Campbell and Cochrane 2000; Gomes, Kogan, and Zhang 2003).”