Asset Pricing with Countercyclical Household Consumption Risk
61 Pages Posted: 15 Feb 2014 Last revised: 11 Aug 2015
Date Written: April 20, 2015
We present evidence that shocks to household consumption growth are negatively skewed, persistent, countercyclical, and drive asset prices. We construct a parsimonious model where heterogeneous households have recursive preferences. A single state variable drives the conditional cross-sectional moments of household consumption growth. The estimated model fits well the unconditional cross-sectional moments of household consumption growth and the moments of the risk free rate, equity premium, price-dividend ratio, and aggregate dividend and consumption growth. The model-implied risk free rate and price-dividend ratio are pro-cyclical while the market return has countercyclical mean and variance. Finally, household consumption risk explains the cross-section of excess returns.
Keywords: household consumption risk, incomplete consumption insurance, idiosyncratic income shocks, asset pricing, equity premium puzzle, risk free rate puzzle, excess volatility puzzle
JEL Classification: D31, D52, E32, E44, G01, G12, J6
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