Essays on Consumption and Asset Pricing Puzzles

Abstract

This thesis contributes to the literature on the consumption-portfolio choice under uncertainty and is motivated by several empirical failures of the standard consumption-based capital asset pricing model (CCAPM). This canonical model has proven disappointing empirically and has even been questioned whether it is theoretically valuable and practically useful\r\neven if it is in some sense the only model we have. The frustration is due to that the model performs no better in practice and generates some well-known consumption puzzles\r\nand asset pricing puzzles. The purpose of the thesis is\r\nto reexamine these puzzles and then to resolve them.\r\n\r\nAfter the debate of Hansen and Singleton (1983) and Hall (1988),\r\nthe estimates of the elasticity of intertemporal substitution (EIS) of consumption in a representative agent model have not resulted in any consensus. Based on this observation, the first chapter of this thesis is focused on resolving the elasticity puzzle or the unresponsiveness to interest rates. We propose a new theoretical and empirical perspective on the relationship between consumption growth and asset returns. In the spirit of Hansen and Singleton (1983), we demonstrate that observed growth rate of consumption responds not only to a specific asset return but also to other asset returns. Empirically, US postwar quarterly data are used to fit the regression model derived in the chapter, and the sample period is 1953Q2-2001Q2.\r\nEmpirical results show that the EIS is greater than 0.1, the maximum value considered possible by Hall (1988). Accordingly,\r\nwe argue that there is no elasticity puzzle in the standard representative agent model.\r\n\r\nThe second chapter provides an explanation for the puzzle of excess sensitivity of consumption to expected income proposed by Flavin (1981). We exploit consumer`s superior information\r\n(i.e., windfalls in investments and in income) to integrate the consumption Euler equations into a generalized Euler equation.\r\nThe implications emerging from the equation can refute much of the empirical evidence against the permanent income hypothesis (PIH). In short, we conclude that consumption growth is sensitive to windfalls in income, but not to expected income. Thus, Friedman`s prescient insight is being formally corroborated in standard utility theory. The equation also provides an alternative approach permitting one more precisely to estimate the preference parameters and much easier to identify the time-series properties of labor income. Empirical results based on U.S. postwar quarterly data show that the EIS is significantly positive and the labor income should follow a nonstationary second-order autoregressive process.\r\n\r\nThe last chapter of the thesis, chapter three, attempts to address the equity premium puzzle, proposed by Mehra and Prescott (1985), and the risk-free rate puzzle, proposed by Weil (1989). These two asset pricing puzzles have troubled financial economists for nearly two decades. To date, there is still no convincing solution for the equity premium puzzle. The CCAPM is apparently inconsistent with the data, especially the annual data in the 1889-1978 period used by Mehra and Prescott (1985). This has led many economists to question whether the model should be abandoned. The purpose of the chapter is to resolve the two puzzles, and then to consolidate the Lucas-Breeden paradigm embedded in the standard CCAPM. We demonstrate that the equity premium puzzle is resulted from the gaps between\r\nthe expected asset returns and the actual ones. These gaps have conventionally been regarded as regression disturbances, and explained as good luck or unexpected windfalls. We introduce an alternative way that, using other good luck to explain a given good luck, can help fill in the specific gap. Results of numerical calculations and parametric estimation show that, the gap has been significantly narrowed down and hence the equity premium and risk-free rate puzzles are successfully resolved.