Working Paper: CEPR ID: DP4067
Authors: Paul Sderlind
Abstract: This Paper studies whether the consumption-based asset-pricing model can explain the cross-section of Sharpe ratios. The constant relative risk aversion (CRRA) model and several extensions (habit persistence, recursive utility and idiosyncratic shocks) all imply that the Sharpe ratio is linearly increasing in the asset?s correlation with aggregate consumption growth. Results from quarterly data on 40 US portfolios (1947?2001) and 10 international portfolios (1957/1971?2001) suggest that both the unconditional and conditional C-CAPM have serious problems: there is a great deal of variation in Sharpe ratios, but most portfolios have relatively similar and low correlations with aggregate consumption growth.
Keywords: Consumption-based asset pricing; Habit persistence; Idiosyncratic risk; Multivariate GARCH; Recursive utility
JEL Codes: E13; E32; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative slope of Sharpe ratio correlation (G40) | CCAPM rejection (G19) |
| Sharpe ratio (G11) | correlation of asset returns with aggregate consumption growth (E21) |
| correlation of asset returns with aggregate consumption growth (E21) | CCAPM explanatory power (G19) |
| idiosyncratic risk and habit persistence (D15) | correlation of asset returns with aggregate consumption growth (E21) |
| correlation of Sharpe ratios and consumption growth correlations (F62) | dispersion in Sharpe ratios (C46) |
| classical CAPM (G19) | explanatory power for international portfolios (G15) |