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Economics Letters 99 (2008) 443 445 www.elsevier.com/locate/econbase

A note on an interpretation to consumption-based CAPM

Liqun Liu, Zijun Wang
Private Enterprise Research Center, Texas A&M University, USA Received 29 January 2007; received in revised form 20 August 2007; accepted 5 September 2007 Available online 14 September 2007

Abstract The consumption-based CAPM pricing rule is sometimes interpreted as implying that the price of an asset with a random payoff falls short of its expected payoff if and only if the random payoff positively correlates with consumption. This note demonstrates that this interpretation to C-CAPM is not generally correct. More importantly, it investigates under what qualifications this intuitive interpretation still holds. 2007 Elsevier B.V. All rights reserved.
Keywords: C-CAPM; Asset pricing; Risk adjustment JEL classifications: G12

1. Introduction Consumption-based capital asset pricing model (C-CAPM), developed in Rubinstein (1976), Lucas (1978), Breeden (1979) and Grossman and Shiller (1981), provides asset pricing models with a firm theoretical foundation grounded in the economic tradition of utility maximization.1 One particular implication of the C-CAPM is that the direction in which an asset's value departs from its expected payoff depends on the covariance between the asset's payoff and the marginal utility of consumption. However, while consumption is directly observable, the marginal utility of consumption is not. Therefore, it is tempting to interpret the covariance between an asset's payoff and the marginal utility of consumption in terms of the covariance between the payoff and consumption itself. Indeed, the C-CAPM pricing rule has been explicitly interpreted by some studies about or using C-CAPM, including the popular textbook by Cochrane (2005), as saying that, under the min Corresponding author. Private Enterprise Research Center, Allen Building, Room 3028, Texas A&M University, College Station, TX 77843-4231, USA. Tel.: +1 979 845 4440; fax: +1 979 845 6636. E-mail address: z-wang@neo.tamu.edu (Z. Wang). 1 C-CAPM remains an active research area. Some recent studies include Campbell and Cochrane (2000), Lettau and Ludvigson (2001), Brant and Wang (2003), Yogo (2006), and Guo, Wang and Yang (2006), among others. 0165-1765/$ - see front matter 2007 Elsevier B.V. All rights reserved. doi:10.1016/j.econlet.2007.09.009

imum assumption of risk aversion, an asset's price falls short of its expected payoff if and only if the asset's payoff positively correlates with consumption. This note demonstrates that this interpretation to C-CAPM, while intuitively appealing, is not literally correct. More importantly, it investigates under what qualifications this intuitive interpretation still holds. The main result is that if consumption can be decomposed into a part that is independent of the random payoff under evaluation and a part that may correlate with the random payoff, and the correlating part is sufficiently small, then the above interpretation to the C-CAPM in terms of the correlation between the random payoff and consumption is again on solid footing. 2. An interpretation to the consumption-based asset pricing rule The basic consumption-based asset pricing rule is well known, and can be expressed as
pt Et   ~ ~ bu Vct1 ~ Et xt1 ~ ~ xt1 bu Vct 1 covu Vct1 ; xt1 ; u Vct Rf

1 where Pt is the price in period t of an asset with random payoff ~ x t + 1 in period t + 1, is the subjective discount factor, Rf is the gross return of the risk-free asset, u() is the marginal utility

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~ function, ct is consumption in period t, and c t + 1 is the consumption in period t + 1. Throughout this note, variables with a on the top are random. Among other things, the pricing rule (1) says that an asset with random future payoff ~t + 1 is worth less than its expected x payoff discounted at the risk-free rate if and only if ~t + 1 is x ~ negatively correlated with u(c t + 1). Because we observe consumption but not marginal utility, it is tempting to interpret the above result in terms of the stochastic relationship between ~ ~ x t + 1 and c t + 1. Indeed, the pricing rule (1) has been interpreted in several important studies using C-CAPM as saying that, under the requirement of risk aversion (u() b 0), an asset with random future payoff ~t + 1 is worth less than its expected payoff x discounted at the risk-free rate if and only if ~t + 1 is positively x ~ correlated with c t + 1 (Weil, 1992; Grant and Quiggin, 2002). Cochrane (2005, page 13) gives the following intuitive explanation for this interpretation: If you buy an asset whose payoff covaries positively with consumption, one that pays well when you are already feeling wealthy, and pays off badly when you are already feeling poor, that asset will make your consumption stream more volatile. You will require a low price to induce you to buy such an asset. However, while intuitively appealing, the above interpretation is not literally correct. Underlying this interpretation is the following proposition that is not true in general. ~ ~ Proposition 1. As long as (u() b 0), cov[u(c ),x ] b 0 if and ~,x ] N 0. ~ only if cov[c Counterexample: We assume that the utility function takes ~ ~ the logarithmic form u(c ) = ln(c ). Therefore, the marginal ~) = 1 / c . In addition, suppose that the economy ~ utility is u(c has three possible states with equal probabilities, and the joint ~ distribution of c and ~ is summarized in Table 1. x ~ The correlation coefficients between c and ~ and between x ~) and ~ can be readily computed. Specifically, (c ,x ) = ~~ u(c x ~),x ) = 0.05. Therefore, ~ is negatively ~ 0.04, and (u(c x ~ ~ correlated with both c and u(c ), contradicting Proposition 1's conclusion. 3. Some positive results The strong intuition behind the interpretation to the C-CAPM pricing rule that is based on the correlation between a random payoff and consumption suggests that the conclusion in Proposition 1 must hold under some further qualifications. Additional restrictions can be made either on utility function u()
Table 1 The joint distribution of ~ and ~ c x ~ c
State 1 State 2 State 3

~ or on statistical properties of ~ and c We have the following x propositions. Proposition 2. Suppose u() is quadratic and u() b 0. Then ~ ~ ~~ cov[u(c ),x ] b 0 if and only if cov[c ,x ] N 0. ~ Proposition 3. Suppose ~ and c are jointly normal and u() x ~),x ] b 0 if and only if cov[c ,x ] N 0. ~ ~~ b 0. Then cov[u(c The proof of Proposition 2 is obvious. The proof of Proposition 3 immediately follows from a relationship established ~ in Rubinstein (1976) that if ~ and c are jointly normal and g() x ~ ~ is any at least once differentiable function, then cov[g(c ),x ] = ~)]cov[c ,x ]. ~~ E [g(c However, the additional restrictions imposed in Propositions 2 and 3 are not appealing because neither the quadratic utility function nor the normal distribution is the desirable choice in financial economics today. In contrast, the following positive result requires no restrictions on the form of utility function (except for risk aversion) or the form of distribution. ~ Proposition 4. Suppose u() b 0 and consumption c can be ~ = y + z , where y is independent of both z ~ ~ ~ ~ decomposed into c ~, and z is sufficiently small. Then cov[u(c),x ] b 0 if and ~ ~ and x ~~ only if cov[c ,x ] N 0. Proof. For simplicity, let u f. Using the Taylor expansion, we have ~ ~ ~ ~ ~ f y z Wf y f Vy z and ~ ~ ~ ~ ~ Ef y z WEf y Ef Vy E z : Therefore,
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ cov f c ; x WE f f y Ef y f Vy z Ef Vy E z x E x g ~; x Ef f Vy z z Ef V y ~ ~ ~ ~ ~ cov f y ~ ~ ~ ~ ~ z Ef Vy Ef V y E z x E x g ~ ~ ~ ~~ ~ E f Vy Ef Vy E zx E x ~ ~ ~ ~ ~ Ef Vy E fz E z x E x g ~ cov z ; x Ef Vy cov c ; x ~ ~ ~ ~ ~ Ef V y

~ ~ ~ ~ Because f (y ) = u(y ) b 0, we have that cov[u(c ),x ] b 0 if ~~ and only if cov[c ,x ] N 0. The intuition for Proposition 4 is closely related to Proposition 2. With a concave quadratic utility function, the marginal utility is a linear and decreasing function of consumption. Therefore, the marginal utility of consumption is negatively correlated with a random payoff if and only if the consumption itself is positively correlated with the random payoff. When the conditions of Proposition 4 are satisfied, we can effectively linearize a nonlinear marginal utility function ~ around y . This linearization plus the independence requirements ~ ~ ~~ ensures that cov[u(c ),x ] and cov[c , x ] have different signs. ~ As an illustration of Proposition 4, let x remain the same as in Table 1 but add a constant 16 to the consumption in all three

~ x 0.98 1.10 1.00

~ u(c ) = 1/ ~ c 0.25 0.22 0.18

4.00 4.50 5.50

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states of the economy. As a result, the new consumption vector ~ becomes c = (20.00, 20.50, 21.50). The idea of this change is to make the random (correlating) component in consumption smaller relative to the non-correlating baseline consumption. Note that the coefficient of variation (defined as the ratio of ~ standard deviation over mean) is 0.16 for c , much larger than ~. Recalculating the correlation coefficients, we have 0.04 for c ~ ~ ~ ~ (c ,x ) = 0.04 and (u(c ), x ) = 0.02. Therefore, with this ~ ~ across-state increase in consumption, (c , x ) remains the same ~, x ) in the counterexample, but (u(c ),x ) takes a ~ ~ ~ as (c ~), x ): The contradiction generated by ~ different sign from (u(c the counterexample disappears. The applicability of Proposition 4 depends on its conditions. In particular, the proposition requires that consumption be decomposed into a large part that is independent of the random payoff under evaluation and a small part that may correlate with the random payoff. It seems plausible that a large part of the consumption in a period is independent of the payoff of a particular asset in that period, for reasons such as subsistence consumption, consumption smoothing, and/or habit formation. Proposition 4 becomes especially relevant when the asset pricing rule (1) is rewritten in terms of consumption growth. Assuming constant relative risk aversion (CRRA), (1) can be alternatively expressed as pt ~ Et xt1 ~ a ~ bcov 1 g t1 ; xt1 ; f R 1

4. Conclusion The consumption-based CAPM pricing rule is sometimes interpreted as implying that the price of an asset with a random payoff falls short of its expected payoff if and only if the random payoff positively correlates with consumption. With a simple counterexample, this note demonstrates that this tempting interpretation to the C-CAPM pricing rule is not literally true. However, the strong intuition behind this interpretation suggests it must be true under some additional qualifications. Sufficient conditions identified in this note include that the instantaneous utility function is quadratic, that the distribution for consumption and the random payoff under evaluation is jointly normal, or that consumption can be decomposed into a part that is independent of the random payoff and a part that may correlate with the random payoff, and the correlating part is sufficiently small. References
Brandt, M.W., Wang, K.Q., 2003. Time-varying risk aversion and unexpected inflation. Journal of Monetary Economics 50, 14571498. Breeden, D.T., 1979. An intertemporal asset pricing model with stochastic consumption and investment opportunities. Journal of Financial Economics 7, 265296. Campbell, J.Y., Cochrane, J.H., 2000. Explanting the poor performance of consumption-based asset pricing models. The Journal of Finance 55, 28632878. Cochrane, J.H., 2005. Asset Pricing (revised edition). Princeton University Press, Princeton. Grant, S., Quiggin, J., 2002. The risk premium for equity: implications for the proposed diversification of the Social Security fund. American Economic Review 92, 11041115. Grossman, S.J., Shiller, R.J., 1981. The determinants of the variability of stock market prices. American Economic Review 71, 222227. Guo, H., Wang, Z., Yang, J., 2006. Does aggregate relative risk aversion change countercyclically over time? Evidence from the stock market. Federal Reserve Bank of St. Louis, Working Papers No. 2006-047. Lettau, M., Ludvigson, S., 2001. Consumption, aggregate wealth, and expected stock returns. The Journal of Finance 56, 815849. Lucas Jr., R.E., 1978. Asset prices in an exchange economy. Econometrica 46, 14291445. Rubinstein, M., 1976. The valuation of uncertain income streams and the pricing of options. Bell Journal of Economics 7, 407425. Weil, P., 1992. Equilibrium asset prices with undiversifiable labor income risk. Journal of Economic Dynamics and Control 16, 769790. Yogo, M., 2006. A consumption-based explanation of expected stock returns. The Journal of Finance 61, 539580.

~ ~ where N 0 is the coefficient of CRRA, and gt1 Jct1 ct =ct is the consumption growth rate. Note that 1 (one) is a constant, ~ which can be regarded as being independent of both g t + 1 and ~ , and g ~ xt+1 t + 1 is small relative to one. Therefore, according to ~ Proposition 4, the price of x t + 1 is less than its expected payoff ~ discounted at the risk-free rate if and only if x t + 1 positively ~ . correlates with g t + 1 Another situation in which the conditions in Proposition 4 are likely to be satisfied is given in Weil (1992) and Grant and Quiggin (2002). In this situation, which is often encountered in the discussion of equity premium puzzle, it is of interest to study ~ ~ ~ ~ the sign of cov[u(y + d ),d ], where y is individual labor income ~ with idiosyncratic risk and d is dividend per capita with aggregate risk. So, the independence requirements in Proposition 4 are satisfied. If it is further assumed that d~ is sufficiently small ~ ~ ~ ~ relative to y , then, according to Proposition 4, cov[u(y + d ),d ] is ~ ~~ negative (positive equity risk premium) because cov[y + d ,d ] is positive.