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On the Robustness of Theoretical Asset Pricing Models

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Abstract
We derive a parsimonious returns-based stochastic discount factor that is robust to model misspecification. We consider a general equilibrium model with heterogeneous agents who can invest their wealth in many assets. As long as (i) agents have (individual-, time-, and state-dependent) recursive preferences that are homothetic in current consumption and continuation value with a common relative risk aversion coefficient "gamma" and (ii) asset returns and individual state variables are conditionally independent (e.g., GARCH processes), we prove that the (minus "gamma")-th power of market return is a valid stochastic discount factor. Within this class of models, asset prices are determined by relative risk aversion and technology alone, and "returns-based asset pricing" is robust to model misspecification as opposed to the consumption-based approach. We recast the equity premium puzzle as a consumption/saving puzzle, not as an asset pricing puzzle.

Suggested Citation

  • Gregory Phelan & Alexis Akira Toda, 2015. "On the Robustness of Theoretical Asset Pricing Models," Department of Economics Working Papers 2015-10, Department of Economics, Williams College.
    • Handle: RePEc:wil:wileco:2015-10
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    More about this item

    Keywords

    Asset pricing puzzles; heterogeneous-agent model; model misspecification; recursive preferences;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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