Long-Horizon Consumption Risk and the Cross-Section of Returns: New Tests and International Evidence

Abstract

This paper investigates whether measuring consumption risk over long horizons can improve the empirical performance of the Consumption CAPM for size and value premia in international stock markets (US, UK, and Germany). We modify the estimation approach of Parker and Julliard (2005) taking commonalities in size and book-to-market sorted portfolios into account. Our results show that, contrary to the findings of Parker and Julliard, the model falls short of providing an accurate description of the cross-section of returns under our modified empirical approach. At the same time, however, measuring consumption risk over longer horizons typically yields lower risk-aversion estimates. Thus, our results suggest that more plausible parameter estimates - as opposed to lower pricing errors - can be regarded as the main achievement of the long-horizon Consumption CAPM.

Keywords: Consumption-based Asset Pricing, Long-Run Consumption Risk, Value Puzzle, International Stock Markets