Neoclassical models with complete markets and without distortions usually imply that asset pricing conditions should be satisfied for a representative closed-economy measure of consumption growth and for any measure of asset returns. Hansen and Singleton (1983), Harvey (1987), and Ferson and Constantinides (1989), among others, have found that models with closed-economy measures of consumption fit best with low risk aversion.
This paper provides statistical and economic interpretations of the low risk aversion estimates obtained for fixed-income assets throughout the finance literature. For a statistical interpretation, Monte Carlo simulations are used to demonstrate that there is a serious downward bias in parameter estimates derived from the consumption asset pricing model when there is measurement error in consumption and in real rates of return. For an economic interpretation, an international version of the asset pricing model is introduced. It is shown that by reducing the effect of country-specific disturbances, the international model produces higher risk aversion estimates than do national models, provided that there is indeed a common consumption component across economies.
Alternative measures of consumption growth that may reduce the bias introduced by measurement or specification errors are examined. An important feature of this approach is that these measures are differentially subject to these errors. Two arguments that characterize the properties and the extent of specification error in various measures of consumption are presented. First, a signal extraction problem is used to show that a measure of international consumption growth across countries reduces the noise introduced by idiosyncratic measurement errors in national measures and, hence, may reveal a common consumption growth signal across countries. Second, it is shown that there are important differences in the way in which the various measures of consumption growth are affected by specification errors owing to difficulties in measuring accurately changes in the quality of nontraded goods.
An econometric method is used to estimate the coefficient of risk aversion and the subjective discount factor in the class of national and international asset pricing models implied by constant risk aversion for alternative measures of consumption growth and asset returns across major industrial countries. The results of asset pricing tests suggest that risk aversion estimates derived from the international asset pricing model are significantly higher than those obtained for national models. Moreover, the international model implies a common degree of risk aversion across industrial countries that is close to unity. More important, the results provide evidence of the international integration of securities markets,