Euler Equation Errors

56 Pages Posted: 5 Feb 2005

See all articles by Martin Lettau

Martin Lettau

University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Sydney C. Ludvigson

New York University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 5 versions of this paper

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

Lettau, Martin and Ludvigson, Sydney C., Euler Equation Errors (January 12, 2006). AFA 2007 Chicago Meetings Paper, Available at SSRN: https://ssrn.com/abstract=661344 or http://dx.doi.org/10.2139/ssrn.661344

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
5106436349 (Phone)

HOME PAGE: http://faculty.haas.berkeley.edu/lettau/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Sydney C. Ludvigson

New York University - Department of Economics ( email )

19 West 4th Street, 6th floor
New York, NY 10012
United States
212-998-8927 (Phone)
212-995-4186 (Fax)

HOME PAGE: http://www.econ.nyu.edu/user/ludvigsons/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
225
Abstract Views
1,861
Rank
127,812
PlumX Metrics