Consumption-Based Asset Pricing When Consumers Make Mistakes
71 Pages Posted: 14 Jun 2021
There are 2 versions of this paper
Consumption-Based Asset Pricing When Consumers Make Mistakes
Date Written: March, 2021
Abstract
I analyze the implications of allowing consumers to make mistakes on the risk-return relationships predicted by consumption-based asset pricing models. I allow for consumption mistakes using a model in which a portfolio manager selects investments on a consumer's behalf. The consumer has an arbitrary consumption policy that could reflect a wide range of mistakes. For power utility, expected returns do not generally depend on exposure to single-period consumption shocks, but robustly depend on exposure to both long-run consumption and expected return shocks. I empirically show that separately accounting for both types of shocks helps explain the equity premium and cross section of stock returns.
JEL Classification: G50, G51, G23, G12, G40, G11
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