Can Costs of Consumption Adjustment Explain Asset Pricing Puzzles

TLDR: In this article, the authors investigate Grossman and Laroque's conjecture that costs of adjusting consumption can account, in part, for the empirical failure of the consumption-based capital asset pricing model (CCAPM).

Abstract: We investigate Grossman and Laroque's (1990) conjecture that costs of adjusting consumption can account, in part, for the empirical failure of the consumptionbased capital asset pricing model (CCAPM). We incorporate small fixed costs of consumption adjustment into a CCAPM with heterogeneous agents. We find that undetectably small consumption adjustment costs can account for much of the discrepancy between the observed variance of nondurable aggregate consumption growth and the predictions of the CCAPM, and can partially reconcile nondurable consumption data with the observed equity premium. We conclude that the CCAPM's implications are nonrobust to extremely small adjustment costs. THE CONSUMPTION-BASED CAPITAL ASSET PRICING MODELS (CCAPMs)1 of Lucas (1978), Breeden (1979), and Grossman and Shiller (1982) have difficulty matching the high volatility of equity returns and the high mean equity premium found in U.S. data. First, the variance of the CCAPM asset pricing kernel is too low to generate plausible equity-return volatility. More precisely, Hansen and Jagannathan (1991) and Cochrane and Hansen (1992) show that, for any conjectured pricing kernel mean, the variance of the kernel is too low to satisfy the Hansen-Jagannathan bounds without implausibly high risk aversion or substantial habit formation.2 Second, the covariance between the CCAPM asset pricing kernel and excess equity returns is too low to generate a plausible equity premium. More precisely, let us define EP' as follows: