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Using Long-Run Consumption-Return Correlations to Test Asset Pricing Models

Jianfeng Yu

University of Minnesota

February 2012

Review of Economic Dynamics, Forthcoming

This paper examines a new set of implications for existing asset pricing models regarding the correlation between returns and consumption growth over both the short run and the long run. The fi ndings suggest that external habit formation models face a challenge in producing two robust facts in aggregate data, namely, that stock market returns lead consumption growth, and that the correlation between returns and consumption growth is higher at low frequencies. To reconcile these facts with a consumption-based model, I demonstrate the need for focusing on models that contain a forward looking consumption component, i.e., models that allow for both trend and cyclical fluctuations in consumption, and that link returns to cyclical fluctuations in consumption. Long-run risk models provide examples of models that contain this consumption component.

Number of Pages in PDF File: 47

Keywords: Long-run risk, habit-formation, forward-looking, long-run correlation

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Date posted: March 14, 2009 ; Last revised: May 17, 2012

Suggested Citation

Yu, Jianfeng, Using Long-Run Consumption-Return Correlations to Test Asset Pricing Models (February 2012). Review of Economic Dynamics, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1359241 or http://dx.doi.org/10.2139/ssrn.1359241

Contact Information

Jianfeng Yu (Contact Author)
University of Minnesota ( email )
321 19th Avenue
Suite 3-122
Minneapolis, MN 55455
United States
HOME PAGE: http://users.cla.umn.edu/~jianfeng/
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