Street-smart asset pricing

Abstract

This article looks at consumption-based asset pricing from a novel perspective that seeks to find common ground between academic research and ‘street wisdom’, i.e. the popularly held beliefs of the stock market participants and observers. I start with an examination of the literature to identify themes of academic research that are compatible with ‘street wisdom’. Using these themes – namely, the themes of ‘fear’ (the fear of rare disasters) and ‘greed’ (the direct preference for wealth) – I develop a modified version of consumption-based capital asset pricing model which juxtaposes the rare disaster framework with the concept of spirit of capitalism. In essence, this is an ‘academic’ model which derives its inspiration from ‘street wisdom’ but aspires to solve ‘academic’ asset pricing puzzles. I succeed in arriving at analytical solutions for asset prices. For the empirical validation of this ‘street-smart’ asset pricing model, I assess its ability to explain the equity premium puzzle using available international historical data sets. The calibration results suggest that the ‘street-smart’ model is indeed smart.

Keywords:

• consumption-based asset pricing
• rare disasters
• spirit of capitalism
• fear; greed
• equity premium puzzle
• risk-free rate puzzle
• asset pricing puzzles

JEL Classification:

• E21
• E22
• E32
• E44
• G1
• G10
• G11
• G12

Acknowledgments

An earlier version of the current paper was presented at the BMRC–QASS Conference on Macro and Financial Economics 2010 under the title ‘Asset pricing with spirit of capitalism in a rare disaster framework’.

Notes

¹ Dalal Street refers to the Bombay Stock Exchange; and Wall Street refers to the New York Stock Exchange.

² ‘Man is dominated by the making of money, by acquisition as the ultimate purpose of his life’ – Weber (1958).