The Role of Heterogeneity in Asset Pricing: The Effect of a Clustering Approach |
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Authors: | Olesya V Grishchenko Marco Rossi |
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Institution: | 1. Division of Monetary Affairs , Board of Governors of the Federal Reserve System , Washington , DC , 20551;2. Mendoza College of Business , University of Notre Dame , Notre Dame , IN , 46556 |
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Abstract: | In this article we use a novel clustering approach to study the role of heterogeneity in asset pricing. We present evidence that the equity premium is consistent with a stochastic discount factor (SDF) calculated as the average of the household clusters’ intertemporal marginal rates of substitution in the 1984–2002 period. The result is driven by the skewness of the cluster-based cross-sectional distribution of consumption growth, but cannot be explained by the cross-sectional variance and mean alone. We find that nine clusters are sufficient to explain the equity premium with relative risk aversion coefficient equal to six. The result is robust to various averaging schemes of cluster-based consumption growth used to construct the SDF. Lastly, the analysis reveals that standard approximation schemes of the SDF using individual household data produce unreliable results, implying a negative SDF. |
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Keywords: | Aggregation Clustering approach Euler equations Household consumption Idiosyncratic consumption risk Incomplete markets |
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