Lazy Investors, Discretionary Consumption, and the Cross

Section of Stock Returns

By Ravi Jagannathan and Yong Wang
October 18, 2005
Presented by Kamal Saeed
ID 571-9580
 Consumption stock betas are computed using year over year consumption
growth based upon fourth quarter ,the consumption-based asset pricing model
(CCAPM) explains the cross section of stock return also using fama and French 3
factor model.
FOR CCAPM investor must make consumption and investment decision
simultaneously at that point in time.
Risk premium investor seeks varies across stock of different types of firm in
systematic way.
Investor are content to seek low return on growth and high return on value high
return for small cap than large cap.
 CCAPM is developed by Rubinstein (1976) Lucas (1978)and Breeden (1979).
Investor are content to accept lower return on those assets that period
better insurance against consumption risk by paying more.
Macroeconomic event un favorably affect consumption choice. First order of
risk premium on an asset is a scale multiple of its exposure to consumption
risk, covariance of the return on the asset is contemporaneous aggregate
consumption growth.
 Growth firm have less exposure to consumption risk compared to
value firms. Smaller firm exposed to consumption risk than large firm.
Mankiw and Shapiro (1986) finds CAPM performs better.
Hansen and Jagannathan (1997) finds CCAPM performs better similar
as CAPM.
Limited success of CCAPM has led to development of consumption
based asset pricing model that allow more general representation of
investor preference for consumption at different time at different
points than assumed in CCAPM (Epstein and zin 1989).
Other author has relaxed some assumption made in all consumption
based asset pricing model that investor can costless adjust
consumption plans Grossman and Laroque (1990)Lynch (1996) Gabaix
and Laibason (2001).
 Daniel and marshal finds correlation between equity returns and
growth rate in aggregate per capita consumption increases as the
holding period over which returns are measured increases consistent
with the consumption being measured with error and investors
adjusting consumption plans only at periodic intervals because of
transaction cost.
The empirical literature in finance and macroeconomics suggest that
investors are more likely to make consumption and portfolio choices
at thend of each calender year because of Christmas and uncertainty
of year end bonuses and the tax consequences of capital gains and
losses.
Estimate risk premium
Consumption b and market b r highly corr
 conclusion
CCAPM performs almost as well as the widely used Fama and French
(1993) three-factor model. Most of the variation in average returns can be
explained by corresponding variation in exposure to the consumption risk
factor. The model performs well for other test assets as well.
econometric specifications for the CCAPM we assume that investors are
more likely to review their consumption-investment plans during the
fourth quarter of every calendar year, and when the economy is in
contraction rather than when it is in expansion. Author find more support
for this assumption than for the standard assumption that investors review
their consumption-investment plans at every instant in time.
 consumption-based model is able to explain the cross-section of average
return on stocks surprisingly well, Author also find evidence indicating that
the model specifications used in empirical study miss some important
aspects of reality. First, the implied market risk premium for bearing
consumption risk is rather high. Second, following Jagannathan and Wang
(1998), when the book-to-market ratio is introduced as an additional
variable in the CSRs, its slope coefficient is significantly different from zero,
indicating model misspecification. This suggests that it would be possible to
construct a set of interesting test assets that pose a challenge to the
consumption-based model by following the methods in Daniel and Titman
(1997). Differential taxation of dividends and capital gains could explain
some of the cross-sectional variation in historical average returns across
stocks not explained by the consumption model, especially along the value-
growth dimension, since a larger part of the historical average return for a
typical value stock is in the form of dividends.
 CCAPM explains the cross-section of stock returns almost as well as the
Fama and French three-factor model, it is not a substitute for the latter
CCAPM requires the use of annual data, very long time series of data are
required for estimating consumption betas accurately, which limits the
CCAPM's applicability. In contrast, betas with respect to factors that are
returns on traded assets can be estimated accurately using relatively short
time series of high-frequency data.
the limitation of models that use such factors is that it is difficult to
interpret what risk they are representing, and why they are systematic and
not diversifiable identified by CCAPM also conclusive by Fama and French
(1993) represent consumption risk, that is, the risk that macroeconomic
events may unfavorably affect consumption choices.