Working Paper

Consumption-Based Asset Pricing When Consumers Make Mistakes

Abstract: I analyze the implications of allowing consumers to make mistakes on the risk-return relationships predicted by consumption-based asset pricing models. I allow for consumption mistakes using a model in which a portfolio manager selects investments on a consumer's behalf. The consumer has an arbitrary consumption policy that could reflect a wide range of mistakes. For power utility, expected returns do not generally depend on exposure to single-period consumption shocks, but robustly depend on exposure to both long-run consumption and expected return shocks. I empirically show that separately accounting for both types of shocks helps explain the equity premium and cross section of stock returns.

Keywords: Asset pricing; Consumer mistakes; Consumption-based asset pricing; Intertemporal CAPM; Long-run risks;

JEL Classification: G50; G51; G23; G12; G40; G11;

https://doi.org/10.17016/FEDS.2021.015

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2021-03-19

Number: 2021-015