The Wealth-Consumption Ratio: A Litmus Test for Consumption-based Asset Pricing Models¤

Hanno Lustig (), Stijn Van Nieuwerburg () and Adrien Verdelhan ()
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Hanno Lustig: UCLA and NBER
Stijn Van Nieuwerburg: NYU and NBER
Authors registered in the RePEc Author Service: Stijn Van Nieuwerburgh

No WP2007-030, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: The volatility of the price-dividend ratio on stocks, the predictability of stock returns, and the lack of predictability in dividend growth are commonly interpreted as evidence of substantial time-variation in risk premia. We construct the wealth-consumption ratio for the U.S., the price-dividend ratio on total wealth. We show that it is at least ¯ve times less volatile than the price-dividend ratio on stocks. The wealth-consumption ratio encodes information about conditional market prices of risk, and hence about asset prices. Matching its properties is a litmus test for consumption-based asset pricing models. Models that match the predictability of equity returns impute too much predictability to total wealth returns and hence too much volatility to the wealth-consumption ratio, because they rely on time variation in the risk premium on total wealth. The smoothness of the wealth-consumption ratio suggests that there may be less time-variation in market prices of risk than commonly inferred from equity prices alone.

New Economics Papers: this item is included in nep-bec, nep-dev, nep-his and nep-knm
Date: 2007-04
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