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http://ssrn.com/abstract=804252
 
 

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Euler Equation Errors


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)

September 2005

NBER Working Paper No. w11606

Abstract:     
The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross- sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

Number of Pages in PDF File: 62

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Date posted: September 14, 2006  

Suggested Citation

Lettau, Martin and Ludvigson, Sydney C., Euler Equation Errors (September 2005). NBER Working Paper No. w11606. Available at SSRN: http://ssrn.com/abstract=804252

Contact Information

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)
77 Bastwick Street
London, EC1V 3PZ
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
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