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

47 Pages Posted: 14 Mar 2009 Last revised: 17 May 2012

Jianfeng Yu

Tsinghua University - PBC School of Finance

Date Written: February 2012

Abstract

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.

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

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: https://ssrn.com/abstract=1359241 or http://dx.doi.org/10.2139/ssrn.1359241

Jianfeng Yu (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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