### Abstract

The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross-sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

Original language | English (US) |
---|---|

Pages (from-to) | 255-283 |

Number of pages | 29 |

Journal | Review of Economic Dynamics |

Volume | 12 |

Issue number | 2 |

DOIs | |

State | Published - Apr 2009 |

### Fingerprint

### Keywords

- Equity premium puzzle
- Euler equation
- Pricing errors
- Recessions

### ASJC Scopus subject areas

- Economics and Econometrics

### Cite this

*Review of Economic Dynamics*,

*12*(2), 255-283. https://doi.org/10.1016/j.red.2008.11.004

**Euler equation errors.** / Lettau, Martin; Ludvigson, Sydney.

Research output: Contribution to journal › Article

*Review of Economic Dynamics*, vol. 12, no. 2, pp. 255-283. https://doi.org/10.1016/j.red.2008.11.004

}

TY - JOUR

T1 - Euler equation errors

AU - Lettau, Martin

AU - Ludvigson, Sydney

PY - 2009/4

Y1 - 2009/4

N2 - The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross-sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

AB - The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross-sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

KW - Equity premium puzzle

KW - Euler equation

KW - Pricing errors

KW - Recessions

UR - http://www.scopus.com/inward/record.url?scp=60449111734&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=60449111734&partnerID=8YFLogxK

U2 - 10.1016/j.red.2008.11.004

DO - 10.1016/j.red.2008.11.004

M3 - Article

VL - 12

SP - 255

EP - 283

JO - Review of Economic Dynamics

JF - Review of Economic Dynamics

SN - 1094-2025

IS - 2

ER -