Testing Consumption-Based CAPM: Evidence from Alternative Models

Abstract:     
Despite its intuitive appeal, empirical evidence on the consumption-based CAPM remains unclear at best. Model restrictions are often rejected, parameters are estimated imprecisely, and inferences can be highly sensitive to model specifications and choice of instruments. This paper tests the fit of the classic C-CAPM and three model extensions against various Australian asset classes. There is very little prior work examining the success of the C-CAPM in an Australian context, and the few existing studies are restricted to the classic C-CAPM. Our results provide some support for the C-CAPM, especially in relation to equity returns. When using instruments, the model implied restrictions cannot be rejected for market indexes, industry portfolios and portfolios cross-sorted on size and book-to-market. However, the evidence rejects the C-CAPM restrictions for size-sorted portfolios and for fixed-income returns. Our results also cast some doubts on the comparative advantage of various extensions of the classic C-CAPM such as habit-persistence and recursive utility models. These model extensions bring significant complexity and computational challenges but without much improvement in the model fit over the classic C-CAPM. Moreover, these extensions, like the classic C-CAPM, also fail to price small stock portfolios and fixed-income assets.

Number of Pages in PDF File: 24

Keywords: consumption CAPM, GMM, habit formation, recursive utility

JEL Classification: G12

working papers series