Reference-dependent asset pricing with a stochastic consumption-dividend ratio

Abstract: We study a discrete-time consumption-based capital asset pricing model under expectations-based reference-dependent preferences. More precisely, we consider an endowment economy populated by a representative agent who derives utility from current consumption and from gains and losses in consumption with respect to a forward-looking, stochastic reference point. First, we consider a general model in which the agent's preferences include both contemporaneous gain-loss utility, that is, utility from the difference between current consumption and previously held expectations about current consumption, and prospective gain-loss utility, that is, utility from the difference between intertemporal beliefs about future consumption. A semi-closed form solution for equilibrium asset prices is derived for this case. We then specialize to a model in which the agent derives contemporaneous gain-loss utility only, obtaining equilibrium asset prices in closed form. Extensive numerical experiments show that, with plausible values of risk aversion and loss aversion, our models can generate equity premia that match empirical estimates. Interestingly, the models turn out to be consistent with some well-known empirical facts, namely procyclical variation in the price-dividend ratio and countercyclical variation in the conditional expected equity premium and in the conditional volatility of the equity premium. Furthermore, we find that prospective gain-loss utility is necessary for the model to predict reasonable values of the price-dividend ratio.