TY - JOUR
AU - Lettau,Martin
AU - Ludvigson,Sydney C.
TI - Euler Equation Errors
JF - National Bureau of Economic Research Working Paper Series
VL - No. 11606
PY - 2005
Y2 - September 2005
DO - 10.3386/w11606
UR - http://www.nber.org/papers/w11606
L1 - http://www.nber.org/papers/w11606.pdf
N1 - Author contact info:
Martin Lettau
Haas School of Business
University of California, Berkeley
545 Student Services Bldg. #1900
Berkeley, CA 94720-1900
Tel: 510/642-6349
Fax: 510/643-1412
E-Mail: lettau@haas.berkeley.edu
Sydney C. Ludvigson
Department of Economics
New York University
19 W. 4th Street, 6th Floor
New York, NY 10002
Tel: 212/998-8927
Fax: 212/995-4186
E-Mail: sydney.ludvigson@nyu.edu
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.
ER -