Consumption-based Capital Asset Pricing Model

Consumption-based Capital Asset Pricing Model, or CCAPM, is a model of the determination of expected asset returns. The foundations of this concept were laid by the research of Robert Lucas (1978) and Douglas Breeden (1979). According to it, the expected-return premium that an asset must offer relative to the risk-free rate is proportional to the covariance of its return with consumption. The coefficient from a regression of an asset’s return on consumption growth is known as its consumption beta. Thus, the central prediction of the CCAPM is that the premiums that assets offer are proportional to their consumption betas.[1]

In the CCAPM, the economy is assumed to be populated by a large number of households that are identical in all respects, including preferences and endowments. This assumption allows decision making to be analyzed by examining the behavior of a single, representative household. Irrespective of the macroeconomic setting, one consequence of the CCAPM assumption that all households are identical is that households will never exchange assets with one another. For instance, it will never be the case that one household will borrow from another, because all households are identical; if one wishes to borrow, all will wish to borrow and there will be no household that wishes to lend. If there are any assets that exist in positive net supply, these must come from outside the household sector (e.g. from governments, businesses, or the rest of world).[2]

The original CAPM assumes that investors are concerned with the mean and variance of the return on their portfolio rather than the mean and variance of consumption. That version of the model therefore focuses on market betas—that is, coefficients from regressions of assets’ returns on the returns on the market portfolio—and predicts that expected-return premiums are proportional to market betas.[3][4] The CCAPM is not in opposition to this concept, and has some further added degree of precision. From the viewpoint of smoothing consumption and risk diversification, an asset is desirable if it has a high return when consumption is low and vice versa.[5]

CCAPM has been used by a plethora of researchers for asset pricing in international markets. In 1988, Simon Wheatley used the CCAPM to test international equity market integration.[6] Cumby tested a consumption- based international asset pricing model using the MSCI market indices data for the US, the UK, Germany, and Japan.[7] Habit-formation models were applied to investigate the predictability and cross-sectional returns from international equity markets by Li and Zhong. It was discovered that surplus consumption associated with a common world SDF can partly explain the returns on most developed equity markets and the habit CCAPM performs well in cross-sectional tests.[8] In 2009, they incorporated both habit formation and uninsurable idiosyncratic risks into an international CCAPM, and found that the model can explain a large fraction of the variation in the cross section of currency and equity premiums in developed countries.[9] Sarkissian studied the CCAPM in foreign exchange markets under the assumption of imperfect risk sharing across countries and found that the new CCAPM with the cross-country consumption dispersion as a factor can better explain the currency risk premium than the classic CCAPM.[10] Bin Li studied the empirical performance of various consumption models for internal equity markets, and concluded that country specific consumption risk is perfectly shared among investors and consequently, only the aggregate world consumption risk matters for asset pricing in a complete market.[11]


  1. Advanced Macroeconomics (Fourth Edition) by David Romer – McGraw Hill Irwin – 2012
  2. Asset Prices in an Exchange Economy by Robert E. Lucas Jr. – Econometrica 46 – 1978
  3. The Valuation of Risky Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets by John Lintner – Review of Economics and Statistics 47 – February 1965
  4. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk by William F. Sharpe – Journal of Finance 19 – September 1964
  5. Intermediate Financial Theory – Second Edition, Jean-Pierre Danthine and John B. Donaldson
  6. Some Tests of International Equity Integration by Simon Wheatley – Journal of Financial Economics 21 – 1988
  7. Consumption Risk and International Equity Returns: Some Empirical Evidence by R. E. Cumby – Journal of International Money and Finance 9 – 1988
  8. Consumption Habit and International Stock Returns by Yuming Li and Maosen Zhong – Journal of Banking & Finance 29 – 2005
  9. International Asset Returns and Exchange Rates by Yuming Li and Maosen Zhong – European Journal of Finance 15 – 2009
  10. Incomplete consumption risk sharing and currency risk premiums by Sergei Sarkissian – Review of Financial Studies 16 – 2003
  11. Testing World Consumption Asset Pricing Models by Bin Li – European Journal of Economics 22 – 2010

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