On the Robustness of Theoretical Asset Pricing Models

Gregory Phelan and Alexis Akira Toda

No 2015-10, Department of Economics Working Papers from Department of Economics, Williams College

Abstract: We derive a parsimonious returns-based stochastic discount factor that is robust to model misspecification. We consider a general equilibrium model with heterogeneous agents who can invest their wealth in many assets. As long as (i) agents have (individual-, time-, and state-dependent) recursive preferences that are homothetic in current consumption and continuation value with a common relative risk aversion coefficient "gamma" and (ii) asset returns and individual state variables are conditionally independent (e.g., GARCH processes), we prove that the (minus "gamma")-th power of market return is a valid stochastic discount factor. Within this class of models, asset prices are determined by relative risk aversion and technology alone, and "returns-based asset pricing" is robust to model misspecification as opposed to the consumption-based approach. We recast the equity premium puzzle as a consumption/saving puzzle, not as an asset pricing puzzle.

Keywords: Asset pricing puzzles; heterogeneous-agent model; model misspecification; recursive preferences (search for similar items in EconPapers)
JEL-codes: D53 D58 D91 G11 G12 (search for similar items in EconPapers)
Pages: 21 pages
Date: 2015-07
New Economics Papers: this item is included in nep-dge, nep-ore and nep-upt
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