An Alternative Representation of the C-CAPM with Higher-Order Risks

Abstract

This paper exploits the concept of expectation dependence to propose an alternative representation of the consumption-based capital asset pricing model (C-CAPM). While the first-degree expectation dependence (FED) drives the C-CAPM's riskiness for a risk-averse investor, the second-degree expectation dependence (SED) is required to account for the downside risk faced by a prudent investor. Theoretical and empirical assessments reveal that the expectation dependence-based C-CAPM can realistically match equity premia, risk-free rates, and variance risk premia. The consumption SED risk emerges as a fundamental source of uncertainty driving asset prices.

Keywords: C-CAPM, Expectation dependence, Higher-order risk, equity risk premium, variance risk premium

JEL Classification: D51, D80, G12