Testable implications of consumption-based asset pricing models with incomplete markets

This paper studies the testable implications of consumption-based asset pricing models with incomplete markets when idiosyncratic income shocks are permanent. It is shown that the theory places no testable restrictions (beyond absence of arbitrage) on either the macroeconomic data or the first N moments of the cross-sectional distribution of consumption growth even if the one-period utility function (degree of risk aversion) is known. More precisely, this paper shows that any “observed” joint process of aggregate consumption, arbitrage-free asset returns, and N moments of the cross-sectional distribution of consumption growth is an equilibrium outcome for some pure discount factor and some process of individual income. The proof is based on the construction of a personal-disaster process (process of extreme idiosyncratic events) which allows for arbitrary variations in idiosyncratic risk without affecting the first N moments of the cross-sectional distribution of consumption growth. © 2003 Published by Elsevier B.V. JEL classification: D52; G12