Idiosyncratic Consumption Risk and the Cross-Section of Asset Returns

This paper investigates the importance of idiosyncratic consumption risk for the cross-sectional variation in average returns on stocks and bonds. If idiosyncratic consumption risk is not priced, the only pricing factor in a multiperiod economy is the rate of aggregate consumption growth. We o®er evidence that the cross-sectional variance of consumption growth is also a priced factor. This demonstrates that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns re°ect their attempts to reduce their exposure to this risk. We ̄nd that over the sample period the resulting two-factor pricing model has lower Hansen-Jagannathan distances than the CAPM and the Fama-French three-factor model. Moreover, in the presence of the market factor and the size and book-to-market factors, the two consumption based factors retain explanatory power. Together with the results of Lettau and Ludvigson (2000), these ̄ndings indicate that consumption-based asset pricing is relevant for explaining the cross-section of asset returns. JEL Classi ̄cation: G12