Consumption-based capital asset pricing model



The consumption-based capital asset pricing model (CCAPM) is a model of the determination of expected (i.e. required) return on an investment. The foundations of this concept were laid by the research of Robert Lucas (1978) and
Douglas Breeden Douglas T. Breeden is the William W. Priest Professor of Finance and former Dean of the Fuqua School of Business, Duke University. He is best known for establishing the use of state prices in financial economics, and for his work on the Consu ...
(1979). The model is a generalization of the
capital asset pricing model In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into accou ...
(CAPM). While the CAPM is derived in a static, one-period setting, the CCAPM uses a more realistic, multiple-period setup. The central implication of the CCAPM is that the expected return on an asset is related to "consumption risk", that is, how much uncertainty in consumption would come from holding the asset. Assets that lead to a large amount of uncertainty offer large expected returns, as investors want to be compensated for bearing consumption risk. The CAPM can be derived from the following special cases of the CCAPM: (1) a two-period model with quadratic utility, (2) two-periods, exponential utility, and normally-distributed returns, (3) infinite-periods, quadratic utility, and stochastic independence across time, (4) infinite periods and log utility, and (5) a first-order approximation of a general model with normal distributions. Formally, the CCAPM states that the expected
risk premium A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...
on a risky asset, defined as the expected return on a risky asset less the risk free return, is proportional to the
covariance In probability theory and statistics, covariance is a measure of the joint variability of two random variables. If the greater values of one variable mainly correspond with the greater values of the other variable, and the same holds for the les ...
of its return and consumption in the period of the return. The consumption
beta Beta (, ; uppercase , lowercase , or cursive ; grc, βῆτα, bē̂ta or ell, βήτα, víta) is the second letter of the Greek alphabet. In the system of Greek numerals, it has a value of 2. In Modern Greek, it represents the voiced labiod ...
is included, and the expected return is calculated as follows:Romer, David. Advanced Macroeconomics, ch. 7. E _ir^f=\beta(r^m-r^f) :where ::E _i/math> = expected return on security or portfolio ::r^f = risk free rate ::\beta = consumption beta (of individual company or weighted average of portfolio), and ::r^m = return from the market


Financial economics Financial models {{finance-stub