The Predictability Implied by Consumption-Based Asset Pricing Models: A Review of the Theory and Empirical Evidence

Journal of Risk Model Validation 12(2), 103–128 DOI: 10.21314/JRMV.2018.190

32 Pages Posted: 12 Sep 2011 Last revised: 10 Nov 2018

See all articles by Jiun-Lin Chen

Jiun-Lin Chen

University of Adelaide; Financial Research Network (FIRN)

Hyoseok (David) Hwang

University of Wisconsin at Eau Claire

Date Written: August 29, 2017

Abstract

The consumption-based models have a lack of predictive power for explaining variability of stock returns. This paper examines two well-known models, Campbell and Cochrane (1999)’s habit model and Bansal and Yaron (2004)’s long-run risks model, to see whether they produce a significant power of return predictability. For the habit model, empirical tests reveal that the state variable, the surplus consumption ratio, explains counter-cyclical time-varying expected returns. The long-run risks model also proves to explain that main sources of volatility in price-dividend ratio are a persistent and predictable consumption growth rate and fluctuating economic uncertainty. The models are also tested by following the work of Kirby (1998) whether they can explain the observed return predictability. Both models fail to generate any significant predictive power. The habit model is relatively strong in volatility, which implies that variation in expected excess return is largely attributable to the time-varying risk aversion.

Keywords: Return predictability, Consumption-based asset pricing model, Habit model, Long-run risks model, Time-varying expected return

JEL Classification: G11, G12, G14, C15

Suggested Citation

Chen, Jiun-Lin and Hwang, Hyoseok, The Predictability Implied by Consumption-Based Asset Pricing Models: A Review of the Theory and Empirical Evidence (August 29, 2017). Journal of Risk Model Validation 12(2), 103–128 DOI: 10.21314/JRMV.2018.190, Available at SSRN: https://ssrn.com/abstract=1925946 or http://dx.doi.org/10.2139/ssrn.1925946

Jiun-Lin Chen

University of Adelaide ( email )

No 233 North Terrace, School of Commerce
Adelaide, South Australia 5005
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Hyoseok Hwang (Contact Author)

University of Wisconsin at Eau Claire ( email )

Eau Claire, WI 54702
United States

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