Euler Equation Errors
56 Pages Posted: 5 Feb 2005
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Euler Equation Errors
Euler Equation Errors
Date Written: January 12, 2006
Abstract
The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. This is evident from the large unconditional Euler equation errors, or pricing errors (terms we use interchangeably), that the model generates when evaluated on cross-sections of stock returns. To understand why the standard model fails, we need alternative models that explain its mispricing. We ask whether four alternative models at the vanguard of consumption-based asset pricing theory explain the standard model's large pricing errors. We find that, in each case, the alternative theories counterfactually imply that the standard model generates negligible asset pricing errors when evaluated on empirically plausible cross-sections of stock returns. In contrast to these results, we provide a stylized example of a limited participation/incomplete markets model capable of rationalizing the pricing errors of the standard consumption-based model; but we also find many examples of such models, in which the consumption of marginal assetholders behaves quite differently from per capita aggregate consumption, that do not explain the large Euler equation errors of the standard representative agent model.
Keywords: Pricing errors, consumption-based asset pricing, CRRA utility
JEL Classification: G12, G10
Suggested Citation: Suggested Citation
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