Idiosyncratic Consumption Risk and the Cross-Section of Asset Returns

42 Pages Posted: 4 Mar 2002 Last revised: 10 Feb 2009

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Kevin Q. Wang

University of Toronto - Joseph L. Rotman School of Management

Date Written: 2004

Abstract

This paper investigates the importance of idiosyncratic consumption risk for the cross-sectional variation in average returns on stocks and bonds. If idiosyncratic consumption risk is not priced, the only pricing factor in a multiperiod economy is the rate of aggregate consumption growth. We offer evidence that the cross-sectional variance of consumption growth is also a priced factor. This demonstrates that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns reflect their attempts to reduce their exposure to this risk. We find that over the sample period the resulting two-factor consumption-based asset pricing model significantly outperforms the CAPM. The model's empirical performance also compares favorably with that of the Fama-French three-factor model. Moreover, in the presence of the market factor and the size and book-to-market factors, the two consumption based factors retain explanatory power. Together with the results of Lettau and Ludvigson (2000), these findings indicate that consumption-based asset pricing is relevant for explaining the cross-section of asset returns.

Keywords: Cross-sectional Asset Pricing, Consumption-based Model, Idiosyncratic Consumption Risk, Incomplete Markets, Measurement Error

JEL Classification: G12

Suggested Citation

Jacobs, Kris and Wang, Kevin Q., Idiosyncratic Consumption Risk and the Cross-Section of Asset Returns (2004). Journal of Finance, Vol. 59, pp. 2211-2252, 2004. Available at SSRN: https://ssrn.com/abstract=302172 or http://dx.doi.org/10.2139/ssrn.302172

Kris Jacobs (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Kevin Q. Wang

University of Toronto - Joseph L. Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6
Canada
416 946 5059 (Phone)
416 971 3048 (Fax)

Paper statistics

Downloads
384
Rank
61,153
Abstract Views
2,640