A new financial asset tends to gain value during recessions and lose value during economic booms. According to the consumption-based CAPM, how should this asset be priced relative to the risk-free rate?
AIt should offer a higher expected return than the risk-free rate, because it is volatile
BIt should offer a lower expected return than the risk-free rate — possibly below it
CIt should offer the same expected return as the risk-free rate, since its gains and losses average out
DIts expected return cannot be determined without knowing its correlation with the stock market
Counter-cyclical assets — those that pay well precisely when consumption is falling and marginal utility is highest — act as insurance. Investors will accept a lower return, even below the risk-free rate, to hold such an asset. The consumption-based CAPM says risk is not about volatility per se but about when an asset pays off: assets that pay poorly during recessions (when every extra dollar is most valuable) require a risk premium, while assets that pay well during recessions command a premium in the form of a price discount — i.e., a below-market return.
Question 2 Multiple Choice
The equity premium puzzle refers to which empirical observation?
AStock markets have been far more volatile than bond markets, contradicting portfolio theory
BThe historically observed excess return on equities is far larger than standard consumption-based models can justify with plausible levels of risk aversion
CInvestors irrationally prefer bonds over stocks despite equities' superior long-run returns
DThe equity premium varies so much across countries that no single model can explain it
The equity premium puzzle (Mehra and Prescott, 1985) is the observation that U.S. stocks have earned roughly 6% per year more than Treasury bills historically, but standard consumption-based models can only generate a premium of about 1% with reasonable risk-aversion coefficients. To match the data, you would need implausibly high risk aversion. This puzzle has driven extensions like habit formation, long-run risk, and rare disaster models — each attempting to explain why investors behave as if the stakes of bad economic times are much higher than standard utility functions capture.
Question 3 True / False
According to the consumption-based CAPM, an asset is risky if it pays poorly in states of the world where aggregate consumption is already falling.
TTrue
FFalse
Answer: True
This is the central insight of the C-CAPM. An asset is risky not because it is volatile in the abstract, but because it fails to pay off precisely when extra income would be most valuable — during recessions when consumption is down and marginal utility is high. An asset that covaries positively with consumption (falls when consumption falls) amplifies pain during bad times and therefore requires a risk premium. The original CAPM's market beta is a proxy for this consumption beta.
Question 4 True / False
Asset prices are primarily backward-looking measures of past economic performance, making them more useful as historical indicators than as signals about future conditions.
TTrue
FFalse
Answer: False
Asset prices are highly forward-looking — they represent the discounted present value of expected future cash flows. This is why financial markets can decline before a recession is officially declared, or rise in anticipation of a recovery. Central banks monitor asset prices precisely because they aggregate information about expected future economic conditions. The bidirectionality between asset prices and the real economy (the wealth effect, collateral channels) further underscores that asset prices are active transmission mechanisms, not passive records.
Question 5 Short Answer
Why do assets that tend to lose value during recessions require a risk premium, even if an investor could theoretically find other uses for that money?
Think about your answer, then reveal below.
Model answer: During recessions, people's consumption is already falling and the marginal utility of each additional dollar is high — extra income is especially valuable. An asset that also loses value in those states compounds the pain: it fails to deliver precisely when it would be most needed. Rational investors demand compensation (a risk premium) to hold such pro-cyclical assets. Conversely, investors willingly accept lower returns on counter-cyclical assets because those assets provide insurance — paying off when income is scarce and marginal utility is highest.
This is the core reframing of the C-CAPM: risk is not variance for its own sake, but variance that is correlated with bad consumption states. A volatile asset that pays off in boom times is far less risky than a less volatile asset that reliably fails in recessions. The equity premium puzzle then becomes: why do standard models, even with this logic, underpredict how large the observed premium is?