Collaborative Research: Relating Asset Pricing Theories to Asset Pricing Facts

New York University, New York NY

Investigators

Abstract

The work described in this proposal aims to build our understanding of the ways in which modern-day asset pricing theories are related to asset pricing facts. This project considers two specific questions of importance to both theoretical and empirical inquiry in financial economics. First, the proposal asks whether leading asset pricing models help explain the large empirical Euler equation errors generated by the standard, representative-agent, consumption-based asset pricing model when confronted with historical data on consumption and cross-sections of risky asset returns. This is important because, if leading asset pricing models are true, then in these models using standard model to price assets should generate large unconditional asset pricing errors, as in the data. Yet surprisingly little research has been devoted to assessing the extent to which modern-day asset pricing theories can explain the significant mispricing of the standard consumption-based model. The research described here is a first step in filling in this gap. Second, the research activity described in this proposal will study the interaction of informational assumptions with the assumptions on the statistical properties of consumption and dividend growth for determining asset prices. An important recent strand of the asset pricing literature has emphasized the possible role of very small but very persistent components in expected dividend growth in generating large equity risk premia, both for an aggregate stock market return and for cross-sections of risky equity returns. A key assumption in this literature is that investors can distinguish such small components in the data even though it is exceedingly difficult to do so econometrically. This proposal explores the ramifications of relaxing this assumption and shows how it can influence the model's implications for asset pricing phenomena. The methodology is both empirical and theoretical. The empirical methodology relies on standard econometric analysis to describe the pricing errors of economic models and the time-series properties of aggregate consumption and stock market cash-flows. The theoretical methodology employs specific models of economic behavior to lend structure and interpretation to the econometric analysis. Broader Impact: The results of the proposed research will be of relevance to policymakers and market economists, as well as academics. Understanding the theoretical frameworks that can explain the behavior of the real and financial sectors of the economy is fundamental for the informed and timely conduct of monetary policy, and for the effectual use of macroeconomic analysis required of industry practitioners. In addition, the research described in this proposal, with its emphasis on the interplay between financial markets and the real economy, can also form a bedrock for studying the ramifications of specific policy initiatives, such as the privatization of social security and the taxation of capital gains and dividend income. The empirical investigations of this research agenda have the potential not only to expand the state of knowledge about what kind of theoretical structures are capable of explaining the behavior of asset markets, but also to facilitate our understanding of the future course of economic activity, its implications for financial markets and household wealth. In the wake of such an unusual period in global equity markets, such an understanding will be crucial to the continued implementation of sound economic policy and financial practice.