Reference-dependent asset pricing with a stochastic consumption-dividend ratio

Paper: arXiv 2401.12856

Authors: Luca De Gennaro Aquino, Xuedong He, Moris Simon Strub, Yuting Yang

Abstract

We study a discrete-time consumption-based capital asset pricing model under expectations-based reference-dependent preferences. More precisely, we consider an endowment economy populated by a representative agent who derives utility from current consumption and from gains and losses in consumption with respect to a forward-looking, stochastic reference point. First, we consider a general model in which the agent’s preferences include both contemporaneous gain-loss utility, that is, utility from the difference between current consumption and previously held expectations about current consumption, and prospective gain-loss utility, that is, utility from the difference between intertemporal beliefs about future consumption. A semi-closed form solution for equilibrium asset prices is derived for this case. We then specialize to a model in which the agent derives contemporaneous gain-loss utility only, obtaining equilibrium asset prices in closed form. Extensive numerical experiments show that, with plausible values of risk aversion and loss aversion, our models can generate equity premia that match empirical estimates. Interestingly, the models turn out to be consistent with some well-known empirical facts, namely procyclical variation in the price-dividend ratio and countercyclical variation in the conditional expected equity premium and in the conditional volatility of the equity premium. Furthermore, we find that prospective gain-loss utility is necessary for the model to predict reasonable values of the price-dividend ratio.

Complexity vs Empirical Score

• Math Complexity: 7.5/10
• Empirical Rigor: 5.5/10
• Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper presents robust theoretical math, deriving semi-closed and closed-form equilibrium asset prices using expectations-based reference-dependent preferences. While it relies heavily on numerical experiments and moment matching rather than comprehensive out-of-sample backtesting, it successfully replicates key stylised empirical facts like countercyclical equity premia.

Research Flowchart

  flowchart TD
    A[Research Goal: Explain Asset Pricing Anomalies via Expectations-Based Preferences] --> B[Model Setup: Agent with Contemporaneous & Prospective Gain-Loss Utility]
    B --> C[Inputs: Stochastic Consumption-Dividend Ratio & Plausible Risk/Loss Aversion Parameters]
    C --> D[Analytical Derivation: Semi-Closed Form General & Closed-Form Special Solutions]
    D --> E[Numerical Experiments & Simulation of Equilibrium Prices]
    E --> F[Key Outcome: Equity Premia Match Empirical Data]
    E --> G[Key Outcome: Prospective Utility Vital for Reasonable Price-Dividend Ratios & Cyclical Variations]

Cited References (101)

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2. Prospect theory: An analysis of decision under risk (1979)
3. Asset Prices under Habit Formation and Catching up with the J oneses (1990)
4. Can prospect theory explain the disposition effect? A new perspective on reference points (2018)
5. Habit formation: A resolution of the equity premium puzzle (1990)
6. Habit persistence and durability in aggregate consumption: E mpirical tests (1991)
7. An intertemporal asset pricing model with stochastic consumption and investment opportunities (1979)
8. The equity premium: A puzzle (1985)

0 of 101 cited works are in the corpus; resolved via arXiv source bundles, Semantic Scholar and OpenAlex. Corpus-wide: 2518 linked papers.