A Consumption-Based Explanation of the Cross Section of Expected Stock Returns

When utility is non-separable in nondurable and durable consumption, optimal portfolio allocation implies a two-factor model in nondurable and durable consumption growth. The model nests the Consumption CAPM as a special case, where the risk price for durable consumption is restricted to zero. I test the model on 25 Fama-French portfolios sorted by size and book-to-market equity. I find that small stocks and value stocks have higher durable consumption betas than large stocks and growth stocks, explaining their high average returns. The consumption-based model model explains the variation in average returns across the 25 portfolios better than the Fama-French three-factor model. JEL classification: E21, G12. First draft: March 7, 2003. ∗Department of Economics, Harvard University. E-mail: yogo@fas.harvard.edu. I thank John Campbell, Borja Larrain, and participants of the Harvard econometrics lunch for helpful comments.

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