Change in Consumption Growth and the Cross-Section of Expected Returns

69 Pages Posted: 20 Apr 2020 Last revised: 3 Aug 2020

See all articles by Dat Mai

Dat Mai

University of Missouri-Columbia

Kuntara Pukthuanthong

University of Missouri, Columbia

Date Written: March 27, 2020

Abstract

We conduct empirical tests of a simplified version of the ratio habit model developed in Abel
(1990), in which habit is extended beyond the preceding period. We show that change in four-year consumption growth---the measure of consumption resulting from our ratio habit preference---explains the joint equity premium--risk-free rate puzzle with a risk aversion coefficient much lower than any existing consumption measures under the standard consumption model. This outperformance of our ratio habit model over the standard model is robust across 18 non-U.S. countries. From 1928-2017, change in four-year consumption growth encompasses other consumption measures in explaining the cross-sectional variation of expected returns on various portfolios and it is the only consumption measure that passes the robust tests of the factor risk premium proposed by Kleibergen and Zhan (2020). While our measure constructed from nondurables does better at pricing the equity premium and risk-free rate, our service-based measure outperforms in explaining the cross-sectional variation of stock returns.

Keywords: ratio habit, equity premium, risk-free rate, puzzles, cross section, robust identification

JEL Classification: G12

Suggested Citation

Mai, Dat and Pukthuanthong, Kuntara, Change in Consumption Growth and the Cross-Section of Expected Returns (March 27, 2020). Available at SSRN: https://ssrn.com/abstract=3562037 or http://dx.doi.org/10.2139/ssrn.3562037

Dat Mai (Contact Author)

University of Missouri-Columbia ( email )

Robert J. Trulaske, Sr. College of Business
Cornell Hall 433
Columbia, MO 65211
United States

HOME PAGE: http://www.maiydat.com/

Kuntara Pukthuanthong

University of Missouri, Columbia ( email )

Robert J. Trulaske, Sr. College of Business
403 Cornell Hall
Columbia, MO 65211
United States
6198076124 (Phone)

HOME PAGE: http://https://kuntara.weebly.com

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