Consumption Risk and the Cost of Equity Capital

Ravi Jagannathan and Yong Wang

No 11026, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We demonstrate, using data for the period 1954-2003, that differences in exposure to consumption risk explains cross sectional differences in average excess returns (cost of equity capital) across the 25 benchmark equity portfolios constructed by Fama and French (1993). We use yearly returns on stocks to take into account well documented within year deterministic seasonal patterns in returns, measurement errors in the consumption data, and possible slow adjustment of consumption to changes in wealth due to habit and prior commitments. Consumption during the fourth quarter is likely to have a larger discretionary component. Further, given the availability of more leisure time during the holiday season and the ending of the tax year in December, investors are more likely to review their asset holdings and make trading decisions during the fourth quarter. We therefore match the growth rate in the fourth quarter consumption from one year to the next with the corresponding calendar year return when computing the latter's exposure to consumption risk. We find strong support for our consumption risk model specification in the data.

JEL-codes: G12 (search for similar items in EconPapers)
Date: 2005-01
New Economics Papers: this item is included in nep-acc, nep-bec, nep-fin and nep-fmk
Note: AP
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Citations: View citations in EconPapers (7)

Forthcoming in the August 2007 issue of the Journal of Finance under the title, "Lazy Investors, Discretionary Consumption, and the Cross Section of Stock Returns."

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