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Consumption-based capital asset pricing models: issues and controversies

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Abstract

This paper discusses the issues and controversies surrounding consumption-based capital asset pricing models (CCAPMs). While CCAPMs provide a chance to explain the phenomena observed in stock markets, their viability is jeopardized owing to the weak predictability of the equity premium and risk-free rate puzzles. Even given market frictions and market incompleteness, CCAPMs must test their validity constantly in the face of the formidable challenges of rival models. Measurement error with respect to time aggregation is also regarded as a major threat, causing the low volatility of consumption and eventually resulting in chaining itself to weak return predictability. In addition, the dual choice problem of portfolio and consumption rooted in CCAPMs guides us into how investors accumulate wealth through the financial market to reach the zenith of expected utility. This paper offers insights as well as understanding into the behavior of an agent and market phenomena in the context of a consumption-based economy.

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Notes

  1. See also Rubinstein (1976) and Grossman and Shiller (1982).

  2. Heaton (1993) shows that measurement error leads to wrong inferences.

  3. See “Appendix” for information about the data source.

  4. See Eq. (8.3.7) in Chapter 8 of Campbell, Lo, and Mackinlay (1997) (CLM hereafter).

  5. Hung (1994) employs a bivariate Markov switching process, characterizing consumption and dividends as asymmetric market fundamentals.

  6. Although Bansal and Yaron (2004) exploit EZ’s utility, their results are fundamentally dependent on the processes underlying returns, consumption growth, and a persistent predictable component that determines the conditional expectation of consumption growth.

  7. Some argue that expected returns should not be as large as historical returns. For instance, the expected aggregate equity premium based on analysts’ earnings forecast was a little above 3.1% in 1985–1998 (Claus and Thomas 2001), while the one-year forecast of the conditional equity premium was 3.5% in 2001 (Welch 2001). These numbers are low compared with the historical equity premium.

  8. In an intertemporal context, the risk-free rate is considered to be an annuity that provides a constant real return over a long period.

  9. Campbell (2001) provides evidence that IES is even smaller.

  10. Equation (8.3.6) in Chapter 8 of CLM.

  11. Siegel (2002) shows a risk premium similar to that of the U.S. stock market for Germany and Japan since 1926.

  12. Equation (8.4.11) in Chapter 8 of CLM.

  13. See Siegel (1998).

  14. Equation (8.4.19) in Chapter 8 of CLM.

  15. Bansal and Yaron (2004) also report a similar risk aversion coefficient.

  16. Durable goods serve as collateral for credit purchases. Therefore, they can be financed, and durable equity loans are available to consumers. Therefore, the market for durable goods, which is constrained by collateral in reality, distorts the consumption allocation across goods and over time. These features supposedly induce different responses of consumption to stock market movement.

  17. By contrast, Dun and Singleton (1986), Eichenbaum and Hansen (1990), and Heaton (1993, 1995) show that durable goods do not help explain the equity premium.

  18. In addition, basic and luxury goods are used by Watcher and Yogo (2004) and food by Mankiw and Zeldes (1991).

  19. Since 1989, the Survey of Consumer Finance has interviewed a fresh sample of households every three years. Hence, household investment has not been tracked.

  20. Brown and Gibbons (1985) assert that temporal aggregation bias is avoided if we access instantaneous consumption sampled at discrete intervals. See footnote 2 in their paper.

  21. Generally, CCAPMs are not obtained if liquidity-constrained income alters the covariance of aggregate consumption growth with asset returns. Instead, an ICAPM is obtained (Brown 1988).

  22. As an economic constraint, Chapman (1998) imposes the restriction on utility to preclude the negative marginal utility in some dates and states of the world.

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Authors and Affiliations

  1. College of Business Administration, Seoul National University, 412, SK Building, San 56-1, Shillim-Dong, Gwanak-gu Seoul, 151-742, Korea

    Wonnho Choi

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This paper is the updated and extended version of one part of my Ph.D. thesis, “A Review of Consumption-based Capital Asset Pricing Model”

Appendix: Data source

Appendix: Data source

Personal income and population data come from lines 1 and 39 from NIPA Table 2.1. personal income and its disposition in Sect. 2 personal income and outlays. Durables, nondurables and services data come from lines 3, 25 and 47 from NIPA Table 2.4.5. Personal consumption expenditures by type of product in Sect. 2 personal income and outlays. Both obtain from Department of Commerce, Bureau of Economic Analysis for the period 1929–2009. Inflation in the rate of change in consumer price index for all urban consumers, not seasonally adjusted (CPI-U NSA) from the US Department of Labor, Bureau of Labor Statistics for the same period. The current standard reference base period is 1982–1984 = 100. That is, all price changes are measured from a base (100) that represents the average index level of the 36-month period encompassing 1982, 1983, and 1984. Value-weighted (including NYSE, AMEX, and NASDAQ) index returns excluding dividends and the three month Treasury Bill rate come from CRSP data files and CRSP’s Fama Risk Free Rates File for the period 1929–2009, respectively. NBER recessions comes from the website of NBER, http://www.nber.org/cycles/recessions.html.

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Choi, W. Consumption-based capital asset pricing models: issues and controversies. Rev Quant Finan Acc 50, 181–205 (2018). https://doi.org/10.1007/s11156-017-0627-z

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