Monday, June 20, 2005

A Consumption-Based Explanation of Expected Returns (one of my favorite sites!) pointed out this gem that links stock returns and consumption. It is forthcoming in the Journal of Finance.

Yogo: A Consumption-Based Explanation of Expected Returns

In the author's words:
"This paper proposes a simple consumption-based explanation of both the cross-sectional variation in expected stock returns and the countercyclical variation in the equity premium."
"In the language of finance, the main findings can be summarized as follows. When
utility is nonseparable in nondurable and durable consumption, optimal portfolio allocation implies a linear factor model in nondurable and durable consumption growth. The risk price for durable consumption is positive, provided that the elasticity of substitution between nondurable and durable goods is higher than the EIS. First, small stocks and value stocks have higher durable consumption betas than big stocks and growth stocks. Simply put, the returns on small stocks and value stocks are more procyclical, explaining their high average returns. Second, the covariance of stock returns with durable consumption growth is higher at business cycle troughs than at peaks. The equity premium is therefore countercyclical because the quantity of risk, measured by the conditional covariance of returns with durable consumption growth, is countercyclical."

Read the whole paper here. Remember, since it is a Journal of Finance link, it will not last long!

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