XXV Edition

1-2 December 2016"

Consumption-Based Asset Pricing and the Cross-Section of Returns: the Role of Leverage

Dam Lammertjan, University of Groningen

We argue that unconditional consumption betas based on unlevered (asset) returns largely capture the differences in expected (asset) returns. Leverage ratios are likely to co-move with changes in the risk premium, thereby inducing positive correlation between equity betas and the risk premium. Correlation between the risk premium and betas is known to generate pricing errors. We propose that the bias can be removed by unlevering returns. We construct a proxy for unlevered returns and analyze the performance of the consumption CAPM using both levered returns and unlevered returns. We do so for i) 25 size and book-to-market sorted portfolios, ii) 25 industry portfolios, and iii) 25 portfolios based on CAPM betas, using the generalized method of moments (GMM), for the period 1962-2014. Our results show that unlevering the returns dramatically improves the performance of the CCAPM.

Area: Asset Pricing and Derivatives

Keywords: Consumption CAPM, Leverage

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