Among the most important pieces of empirical evidence against the standard representative agent, consumption-based asset pricing paradigm are the formidable unconditional Euler equation errors the model produces for cross-sections of asset returns. Here we ask whether calibrated leading asset pricing models - specifically developed to address empirical puzzles associated with the standard paradigm - explain the mispricing of the standard consumption-based model when evaluated on cross-sections of asset returns. We find that, in many cases, they do not. We present several results. First, we show that if the true pricing kernel that sets the unconditional Euler equation errors to zero is jointly lognormally distributed with aggregate consumption and returns, such a kernel will not rationalize the magnitude of the pricing errors generated by the standard model, particularly when the curvature of utility is high. Second, we show that leading asset pricing models also do not explain the significant mispricing of the standard paradigm for plausibly calibrated sets of asset returns, even though in those models the pricing kernel, returns, and consumption are not jointly lognormally distributed. Third, in contrast to the above results, we provide one example of a limited participation/incomplete markets model capable of explaining larger pricing errors for the standard model; but we also find many examples of such models, in which the consumption of marginal assetholders behaves quite differently from per capita aggregate consumption, that do not explain the large Euler equation errors of the standard representative agent model.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
page. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Publisher Info
Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
5245.
Martin Lettau & Sydney C. Ludvigson, 2005.
"Euler Equation Errors,"
NBER Working Papers
11606, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Campbell, John Y., 2003.
"Consumption-based asset pricing,"
Handbook of the Economics of Finance,
in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887
Elsevier.
[Downloadable!] (restricted)
Other versions:
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)
Martin Lettau & Sydney Ludvigson, 2009.
"Euler Equation Errors,"
Review of Economic Dynamics,
Elsevier for the Society for Economic Dynamics, vol. 12(2), pages 255-283, April.
[Downloadable!] (restricted)
Other versions: