Third, the consumption-based asset pricing model does not properly account for the facts that the yield curve is on average upward sloping (at least up to medium term bonds), that government intervention affects its slope, and that long-term bonds feature substantial price volatility (see, e.g., Shiller 1989, chapter 12.) It is often argued that the term premium results from the price risk of longterm bonds. However, this argument is not supported by a complete market model like CAPM, because price risk per se only entails a reshuffling of wealth among investors and involves no aggregate risk that would deliver a premium.

Fourth, the consumption-based asset pricing model has not guided the important advances in Autoregressive Conditional Heteroskedasticity (ARCH) models. ARCH models and their generalizations allow the covariance matrix of innovations to be state-contingent in order to reflect observations by Mandelbrot (1963), Fama (1965) and Black (1976) that variances and covariances of asset prices change through time and that volatility tends to be clustered across time and across assets.

A proper treatment of these empirical discrepancies of the consumption-based asset pricing model lies outside the limited scope of this exploratory paper. Let us briefly indicate though how the liquidity approach could help to bridge the gap between theory and empirics.

First, concerning the equity premium puzzle we find that Treasuries and other high-grade securities offer better insurance against shortfalls in corporate earnings and other liquidity needs than do stocks. To highlight this point, we deliberately assume that consumers are risk neutral, so that stocks and bonds alike would trade at par in the standard model; yet in our model bonds command a liquidity premium and trade at a discount relative to stocks.

Second, by assuming risk-neutral consumers, we eliminate consumer I MR S’s as drivers of asset price movements. Instead prices will be responding to changes in corporate IMRS’s, which in turn are influenced by corporate demand for liquidity. The theoretical implications are different.

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