02510cam a22002657 4500001000700000003000500007005001700012008004100029100002000070245008800090260006600178490004200244500002000286520138100306530006101687538007201748538003601820690005701856690011201913700002502025710004202050830007702092856003802169856003702207w11606NBER20170220061033.0170220s2005 mau||||fs|||| 000 0 eng d1 aLettau, Martin.10aEuler Equation Errorsh[electronic resource] /cMartin Lettau, Sydney C. Ludvigson. aCambridge, Mass.bNational Bureau of Economic Researchc2005.1 aNBER working paper seriesvno. w11606 aSeptember 2005.3 aThe 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. aHardcopy version available to institutional subscribers. aSystem requirements: Adobe [Acrobat] Reader required for PDF files. aMode of access: World Wide Web. 7aG10 - General2Journal of Economic Literature class. 7aG12 - Asset Pricing • Trading Volume • Bond Interest Rates2Journal of Economic Literature class.1 aLudvigson, Sydney C.2 aNational Bureau of Economic Research. 0aWorking Paper Series (National Bureau of Economic Research)vno. w11606.4 uhttp://www.nber.org/papers/w1160641uhttp://dx.doi.org/10.3386/w11606