Hyperbolic utility consumption -CAPM with time variation

Seung-Mo Jeff Hong, Fordham University

Abstract

In the past the studies done about consumption and the financial market generally produced results that would only work to discount the credibility of consumption-based asset pricing models. This study was motivated by the idea that a model based on hyperbolic utility risk aversion mechanism might be an alternative solution to close this gap between consumption and actual financial market. Accordingly, this study showed that Hyperbolic Utility CCAPM with time-varying technique was a better model than Vector Autoregression model of Campbell & Shiller at least for the scope of this study. ^ The model also reinstated relevance of risk aversion & utility function in constructing an asset-pricing model. It also showed that Hyperbolic Absolute Risk Aversion offers a more realistic explanation why consumption tends to be smooth vis-à-vis the market. Even if HARA consumption may not completely track income, the model still closely tracked and forecasted the returns path. ^ On the other hand, the traditional risk aversion mechanism of Constant Relative Risk Aversion was shown to be unable to explain progressively smoothing consumption, because CRRA assumes proportional changes in consumption in response to changes in relative income. From this, we may infer that there may exist a point or a separating equilibrium where MPCHARA = MPCCRRA past which MPCHARA < MPCCRRA somewhere on the consumption curve. Therefore, it answers at least the puzzle why consumption is too smooth, and partially the puzzle why risk premium is too high to be explained by the smooth consumption. This dissertation also shows how and why consumption may drop out in steady state and/or under Lucas Tree model. The model also outperformed a simple Data Generating Process (ARMA) in an out-of-sample testing. The hypothetical portfolio consisting of assets selected by the criteria that the model suggests also fared well vis-à-vis the market, supporting the practical value of Model. ^

Subject Area

Economics, General|Economics, Commerce-Business|Economics, Finance

Recommended Citation

Seung-Mo Jeff Hong, "Hyperbolic utility consumption -CAPM with time variation" (January 1, 2000). ETD Collection for Fordham University. Paper AAI9999826.
http://fordham.bepress.com/dissertations/AAI9999826

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