Time-Varying Equity Premium with Noisy Consumption 

Fisher College of Business Working Paper No. 2023-03-018

Charles A. Dice Working Paper No. 2023-18

60 Pages Posted: 23 Jun 2023 Last revised: 22 Jul 2024

See all articles by Alessandro Melone

Alessandro Melone

Ohio State University (OSU) - Fisher College of Business

Date Written: June 29, 2023

Abstract

This paper examines the return predictability implications of mismeasured consumption. I introduce a novel state variable, the consumption gap, which identifies deviations from a slow-moving consumption component. Using a simulated habit economy, I show that the predictive power of the consumption gap is largely unaffected by the severity of measurement error, unlike surplus-consumption. Empirically, the consumption gap forecasts stock returns in-and out-of-sample at horizons from one quarter to five years, generating annualized average utility gains of 4.3% for a mean-variance investor. Cross-sectional tests provide further evidence that the consumption gap tracks time variation in the price of market risk.

Keywords: Consumption-Based Asset Pricing, Measurement Error, Time-Varying Equity Premium, Habit Formation Model, Conditioning Variable. JEL codes: C22, E32, E44, G12

JEL Classification: C22, E32, E44, G12

Suggested Citation

Melone, Alessandro, Time-Varying Equity Premium with Noisy Consumption  (June 29, 2023). Fisher College of Business Working Paper No. 2023-03-018, Charles A. Dice Working Paper No. 2023-18, Available at SSRN: https://ssrn.com/abstract=4488540 or http://dx.doi.org/10.2139/ssrn.4488540

Alessandro Melone (Contact Author)

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

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