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The role of household debt and delinquency decisions in consumption-based asset pricing

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Abstract

I incorporate household debt and delinquency decisions into a standard model of lifecycle consumption-saving-investment. I also impose a punishment to the delinquent behavior by assuming that the percentage of endowment available is a linear function of the default decision. Theoretically such additional investor decisions are playing a relevant role in terms of completing markets. In practice, it enables me to derive an extended system of Euler equations which does not alter consumption-based fundamental asset pricing equation. It imposes the pricing kernel to account jointly for two additional first-order conditions. I perform empirical exercises aiming to price equity premium in United States from 1987:1 to 2018:1. I find significant elasticity of intertemporal substitution in consumption of the representative agent ranging from 0.24 to 0.55 and risk aversion from 1.82 to 3.51. This approach is also useful to account for the cross-section behavior of domestic assets. I can also use this framework to draw bounds for the household decisions on loan and delinquency and to propose a new rule of thumb relating preferences parameters and credit variables.

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Fig. 1

Data source: FRED

Fig. 2
Fig. 3

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Notes

  1. Concerning the personal bankruptcy, I recognize the existence and the relevance of this formal procedure that removes unsecured debt obligations subject to some specific cases. However, I rely on one of the main findings reported in Athreya et al. (2009) to rule out this possibility. They find that unsecured credit markets pass-through increased income risk to consumption in U.S., irrespective of bankruptcy policy.

  2. This variable is not used in the empirical exercise performed here and is not reported in Fig. 1.

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Acknowledgements

For helpful comments on earlier drafts, I thank Alex Ferreira, Carlos da Costa, Costas Meghir, Fábio Gomes, Giovanni Beviláqua, Jaime de Jesus Filho, Jefferson Bertolai, Marcelo Fernandes, Márcio Veras and Thiago Souza. Also, I thank seminar participants at various institutions and conferences and the anonymous referees for relevant remarks. All errors are mine.

Funding

I gratefully acknowledge financial support from CNPq-Brazil.

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  1. CAEN Graduate School of Economics, Federal University of Ceará, Avenida da Universidade, 2760, Fortaleza, CE, CEP 60.020.181, Brazil

    Paulo Rogério Faustino Matos

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Correspondence to Paulo Rogério Faustino Matos.

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Matos, P.R.F. The role of household debt and delinquency decisions in consumption-based asset pricing. Ann Finance 15, 179–203 (2019). https://doi.org/10.1007/s10436-019-00344-1

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