Consumption Risk and the Cost of Equity Capital

We demonstrate, using data for the period 1954-2003, that di¤erences in exposure to consumption risk explains cross sectional di¤erences in average excess returns (cost of equity capital) across the 25 benchmark equity portfolios constructed by Fama and French (1993). We use yearly returns on stocks to take into account well documented within year deterministic seasonal patterns in returns, measurement errors in the consumption data, and possible slow adjustment of consumption to changes in wealth due to habit and prior commitments. Consumption during the fourth quarter is likely to have a larger discretionary component. Further, given the availability of more liesure time during the holiday season and the ending of the tax year in December, investors are more likley to review their asset holdings and make trading decisions during the fourth quarter. We therefore match the growth rate in the fourth quarter consumption from one year to the next with the the corresponding calendar year return when computing the latter’s exposure to consumption risk. We …nd strong support for our consumption risk model speci…cation in the data. Ravi Jagannathan: Kellogg School of Management at Northwestern University and the National Bureau of Economic Research; Yong Wang: Kellogg School of Management, Northwestern University. We thank Kent Daniel, Deborah Lucas, Annette Vissing-Jorgensen, and Da Zhi for helpful discussions. We are responsible for all errors and omissions. 1 USC FBE FINANCE SEMINAR presented by Ravi Jagannathan FRIDAY, April 22, 2005 10:30 am – 12:00 pm, Room: JKP-104