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410
By Force of Habit: A ConsumptionBased Explanation of Aggregate Stock Market Behavior." Working Paper no. 4995
, 1995
"... We present a consumptionbased model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the longhorizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much ..."
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Cited by 1018 (46 self)
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We present a consumptionbased model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the longhorizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much of the history of stock prices from consumption data. It explains the short and longrun equity premium puzzles despite a low and constant riskfree rate. The results are essentially the same whether we model stocks as a claim to the consumption stream or as a claim to volatile dividends poorly correlated with consumption. The model is driven by an independently and identically distributed consumption growth process and adds a slowmoving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia: Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of longrun average consumption growth.
Risks for the long run: A potential resolution of asset pricing puzzles
 JOURNAL OF FINANCE
, 1994
"... We model consumption and dividend growth rates as containing (i) a small longrun predictable component and (ii) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin’s (1989) preferences, can explain ke ..."
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Cited by 449 (36 self)
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We model consumption and dividend growth rates as containing (i) a small longrun predictable component and (ii) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin’s (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better longrun growth prospects raise equity prices. The model can justify the equity premium, the riskfree rate, and the volatility of the market return, riskfree rate, and the pricedividend ratio. As in the data, dividend yields predict returns and the volatility of returns is timevarying.
Trying to Explain Home Bias in Equities and Consumption
 Journal of Economic Literature
, 1999
"... Domestic investors hold a substantially larger proportion of their wealth portfolios in domestic assets than standard portfolio theory would suggest, a phenomenon called "equity home bias. " In the absence of this bias, investors would optimally diversify domestic output risk using foreign ..."
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Cited by 340 (4 self)
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Domestic investors hold a substantially larger proportion of their wealth portfolios in domestic assets than standard portfolio theory would suggest, a phenomenon called "equity home bias. " In the absence of this bias, investors would optimally diversify domestic output risk using foreign equities. Therefore, consumption growth rates would tend to comove across countries even when output growth rates do not. Empirically, however, consumption growth rates tend to have a lower correlation across countries than do output growth rates, a phenomenon I call "consumption home bias. " In this paper, I discuss these two biases and their potential relationship. I appreciate useful suggestions and comments from three anonymous referees and John Pencavel, the editor. I am also grateful to Michael Adler, Urban Jermann, and Amir Yaron for helpful discussions. Any errors or omissions are my responsibility alone. 1 Do individuals hold the optimal portfolio? Do they do a good job of hedging risks? The answer to these questions are clearly important for understanding the economy. If individuals indeed hedge risk optimally, then resources are allocated to their most efficient uses. If not, then many other questions arise. Why not? What is the explanation for these inefficiencies? And what
Nonparametric Estimation of StatePrice Densities Implicit In Financial Asset Prices
 JOURNAL OF FINANCE
, 1997
"... Implicit in the prices of traded financial assets are ArrowDebreu prices or, with continuous states, the stateprice density (SPD). We construct a nonparametric estimator for the SPD implicit in option prices and derive its asymptotic sampling theory. This estimator provides an arbitragefree metho ..."
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Cited by 244 (5 self)
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Implicit in the prices of traded financial assets are ArrowDebreu prices or, with continuous states, the stateprice density (SPD). We construct a nonparametric estimator for the SPD implicit in option prices and derive its asymptotic sampling theory. This estimator provides an arbitragefree method of pricing new, complex, or illiquid securities while capturing those features of the data that are most relevant from an assetpricing perspective, e.g., negative skewness and excess kurtosis for asset returns, volatility "smiles" for option prices. We perform Monte Carlo experiments and extract the SPD from actual S&P 500 option prices.
Conditional skewness in asset pricing tests
 Journal of Finance
, 2000
"... If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. We formalize this intuition with an asset pricing model that incorporates conditional skewness. Our results show that conditional skewness helps explain the crosssectional variation of expect ..."
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Cited by 203 (6 self)
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If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. We formalize this intuition with an asset pricing model that incorporates conditional skewness. Our results show that conditional skewness helps explain the crosssectional variation of expected returns across assets and is significant even when factors based on size and booktomarket are included. Systematic skewness is economically important and commands a risk premium, on average, of 3.60 percent per year. Our results suggest that the momentum effect is related to systematic skewness. The low expected return momentum portfolios have higher skewness than high expected return portfolios. THE SINGLE FACTOR CAPITAL ASSET PRICING MODEL ~CAPM! of Sharpe ~1964! and Lintner ~1965! has come under recent scrutiny. Tests indicate that the crossasset variation in expected returns cannot be explained by the market beta alone. For example, a growing number of studies show that “fundamental” variables such as size, booktomarket value, and price to earnings ratios
Risks and Portfolio Decisions involving Hedge Funds
, 2002
"... Hedge funds are known to exhibit nonlinear optionlike exposures to standard asset classes and therefore the traditional linear factor model provides limited help in capturing their riskreturn tradeoffs. We address this problem by augmenting the traditional model with optionbased risk factors. O ..."
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Cited by 134 (15 self)
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Hedge funds are known to exhibit nonlinear optionlike exposures to standard asset classes and therefore the traditional linear factor model provides limited help in capturing their riskreturn tradeoffs. We address this problem by augmenting the traditional model with optionbased risk factors. Our results show that a large number of equityoriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index, and therefore bear significant lefttail risk, risk that is ignored by the commonly used meanvariance framework. Using a meanconditional ValueatRisk framework, we demonstrate the extent to which the meanvariance framework underestimates the tail risk. Working with the underlying systematic
Junior can’t borrow: A new Perspective on the equity premium puzzle
 Quarterly Journal of Economics
, 2002
"... Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlappinggenerations economy in which consumers are subject to a borrowing constraint. The key featu ..."
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Cited by 129 (14 self)
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Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlappinggenerations economy in which consumers are subject to a borrowing constraint. The key feature captured by the OLG economy is that the bulk of the future income of the young consumers is derived from their wages forthcoming in their middle age, while the bulk of the future income of the middleaged consumers is derived from their savings in equity and bonds. The young would like to borrow and invest in equity but the borrowing constraint prevents them from doing so. The middleaged choose to hold a diversified portfolio that includes positive holdings of bonds and this explains the demand for bonds. Without the borrowing constraint, the young borrow and invest in equity, thereby decreasing the mean equity premium and increasing the rate of interest.
RiskSensitive Real Business Cycles
 JOURNAL OF MONETARY ECONOMICS
, 1998
"... This paper considers the business cycle, asset pricing, and welfare effects of increased risk aversion, while holding intertemporal substitution preferences constant. I show that increasing risk aversion does not significantly affect the relative variabilities and comovements of aggregate quanti ..."
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Cited by 128 (3 self)
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This paper considers the business cycle, asset pricing, and welfare effects of increased risk aversion, while holding intertemporal substitution preferences constant. I show that increasing risk aversion does not significantly affect the relative variabilities and comovements of aggregate quantity variables. At the same time, it dramatically improves the model's asset market predictions. The welfare costs of business cycles increase when preference parameters are chosen to match financial data.
Nonlinear Pricing Kernels, Kurtosis Preference, and the CrossSection of Assets Returns
 Journal of Finance
, 2002
"... This paper investigates nonlinear pricing kernels in which the risk factor is endogenously determined and preferences restrict the definition of the pricing kernel. These kernels potentially generate the empirical performance of nonlinear and multifactor models, while maintaining empirical power and ..."
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Cited by 109 (2 self)
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This paper investigates nonlinear pricing kernels in which the risk factor is endogenously determined and preferences restrict the definition of the pricing kernel. These kernels potentially generate the empirical performance of nonlinear and multifactor models, while maintaining empirical power and avoiding ad hoc specifications of factors or functional form. Our test results indicate that preferencerestricted nonlinear pricing kernels are both admissible for the cross section of returns and are able to significantly improve upon linear single and multifactor kernels. Further, the nonlinearities in the pricing kernel drive out the importance of the factors in the linear multifactor model. A PRINCIPAL IMPLICATION OF THE Capital Asset Pricing Model ~CAPM! is that the pricing kernel is linear in a single factor, the portfolio of aggregate wealth. Numerous studies over the past two decades have documented violations of this restriction. 1 In response, researchers have examined the performance of alternative models of asset prices. These models have generally fallen into two classes: ~1! multifactor models such as Ross ’ APT or Merton’s ICAPM, in which factors in addition to the market return determine asset prices; or ~2! nonparametric models, such as Bansal et al. ~1993!, Bansal and Viswanathan ~1993!, and Chapman ~1997!, in which the pricing kernel is not
Empirical pricing kernels
, 2001
"... This paper investigates the empirical characteristics of investor risk aversion over equity return states by estimating a timevarying pricing kernel, which we call the empirical pricing kernel (EPK). We estimate the EPK on a monthly basis from 1991 to 1995, using S&P 500 index option data and a ..."
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Cited by 97 (2 self)
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This paper investigates the empirical characteristics of investor risk aversion over equity return states by estimating a timevarying pricing kernel, which we call the empirical pricing kernel (EPK). We estimate the EPK on a monthly basis from 1991 to 1995, using S&P 500 index option data and a stochastic volatility model for the S&P 500 return process. We find that the EPK exhibits countercyclical risk aversion over S&P 500 return states. We also find that hedging performance is significantly improved when we use hedge ratios based the EPK rather than a timeinvariant pricing kernel.