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.
File(s): File format is application/pdf https://www.federalreserve.gov/econres/feds/files/2021015pap.pdf
Part of Series: Finance and Economics Discussion Series
Publication Date: 2021-03-19