Consumption Based Asset Pricing Models
In studying the consumption based dynamic asset pricing theory we have first presumed that there is an exogenously given dividend stream which is equal to the consumption stream of the agent whose utility function could take on different forms. For the case of simple utility functions we have also derived the Euler equation as the essential equation to study dynamic asset pricing. Appendix 2 derives the Euler equation from dynamic programming. As we also have shown, using preferences such as log or power utility, the equity premium and the Sharpe ratio cannot match the equity premium and the Sharpe ratio of actual time series data. For those preferences a too high parameter of risk aversion and/or a strong covariance of consumption growth with asset returns are required which one does not find in the data. The question thus remains whether models that more explicitly take into account production activities or rely on other types of preferences may be able to provide a better match of theory and the data. Asset pricing for production economies is taken up next. Other preferences are considered in Chap. 15.
KeywordsEuler Equation Asset Price Risky Asset Asset Return Sharpe Ratio
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