From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors

Mathias S. Kruttli

No 2016-027, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: This paper compares consumption-based asset pricing models based on the forecasting performance of investors who use economic constraints derived from the models to predict the equity premium. Three prominent asset pricing models are considered: Habit Formation, Long Run Risk, and Prospect Theory. I propose a simple Bayesian framework through which the investors impose the economic constraints as model-based priors on the parameters of their predictive regressions. An investor whose prior beliefs are rooted in the Long Run Risk model achieves more accurate forecasts overall. The greatest difference in performance occurs during the bull market of the late 1990s. During this period, the weak predictability of the equity premium implied by the Long Run Risk model helps the investor to not prematurely anticipate falling stock prices.

Keywords: Bayesian econometrics; Consumption-based asset pricing; Return predictability (search for similar items in EconPapers)
JEL-codes: G11 G12 G17 (search for similar items in EconPapers)
Pages: 65 pages
Date: 2016-03-29
New Economics Papers: this item is included in nep-for
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2016-27

DOI: 10.17016/FEDS.2016.027r1

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