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| Type | Master's Thesis |
| Scope | Discipline-based scholarship |
| Title | Conditional Consumption Volatility and the Pricing Kernel Puzzle |
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| Institution | University of Zurich |
| Faculty | Faculty of Business, Economics and Informatics |
| Number of Pages | 40 |
| Date | 2020 |
| Zusammenfassung | The pricing kernel is a fundamental part of many asset pricing models and is therefore an integral element of the research conducted in this field. The pricing kernel aggregates investor preferences for payoffs in different states of the world. Assuming the absence of arbitrage, asset prices can be characterized as the expected value of the product of the pricing kernel and the asset payoffs. Unsurprisingly, its enormous breadth of information has led to numerous attempts by renowned researchers in the past to derive an accurate estimate of such a pricing kernel. Since the beginning of the twenty-first century, findings by several researchers that contradict asset pricing theories have triggered a broad echo in the financial sciences. With Jackwerth (2000), Aït-Sahalia and Lo (2000), and Rosenberg and Engle (2002) surprisingly observing a func-tional form of the pricing kernel that deviated from theory, the pricing kernel puzzle was born. Whereas theory implies pricing kernels monotonically decreasing with financial market growth rates, empirical studies have shown a partially increasing section in the range between -4 and 2% financial market returns. In this thesis, I introduce the reader to the subject and the associated research question of my investiga-tion. Thereafter, I explain the theoretical background and discuss studies in which the pricing kernel puzzle has been identified and replicated. I also present proposed solutions to the pricing kernel puzzle, which mostly fail on account of requiring unrealistic parameters to explain the puzzle. Furthermore, I discuss the most recent insights on the characteristics of consumption data and their implications for consumption-based asset pricing models and how I deal with these difficulties in my analysis. In the next chapter, I describe the data used in my research. After this, I introduce a modified consumption-based asset pricing model and estimate empirical pricing kernels based on it. The last chapter concludes the thesis. More than 30 years ago, Mehra and Prescott (1985) showed that the very low level of volatility in con-sumption growth and the moderate correlation between equity market and consumption growth lead to the consumption-based capital asset pricing model (CCAPM) predicting much lower risk premia for equities than are actually observed in the market. Since then, most attempts to explain the high equity premium despite low consumption volatility have been based on augmenting existing, simple models in such ways that low volatility combined with relatively low risk aversion would still result in sufficiently high risk premia. More recently, the low volatility in consumption data itself has become the subject of increased interest (Savov (2011) and Kroencke (2017)). Kroencke (2017) states that the data for US consumption are system-atically smoothed by the Bureau of Economic Analysis (BEA) before they are published, and he shows that “unfiltering” these data increases their correlation with US stock returns and leads to a lower risk aversion being required to explain the equity premium. Most studies analysing the pricing kernel puzzle are based on an examination of the market using option prices, assuming that a representative investor hedges his intertemporal consumption with state securities. For this purpose, risk neutral and subjective distributions are estimated to represent the pricing kernel. Such studies assume that the real economy develops in line with the financial market, which is why hedging consumption via the financial market is considered to be reasonable. In my study, however, I distinguish between the development of the real economy and that of the financial market. This differentiation is based on my assumption that the representative investor wants to hedge his consumption depending on the de-velopment of the real economy, which also has an important influence on his income. With this specifica-tion, I allow the representative investor to hedge against the real risk. This model specification allows a simple extension of the formerly used consumption-based asset pricing model by means of the dimension of the real economy and therefore, constitutes an interesting contribution to illustrate the relationship be-tween the financial market and the real economy in relation to asset pricing. To model the development of the real economy, I use quarterly National Income and Product Accounts (NIPA) consumption data from 1950 to 2018 from Kroencke (2017), from which it is possible to capture unfiltered consumption data. This so-called unfiltering process leads to an increased volatility of consumption growth and thus qualifies unfil-tered consumption growth data as a determining variable conditional on the financial market for the inves-tigation of the pricing kernel puzzle. The modified model is based on a power utility specification. |
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