Knowledge that Transforms

This article tests a simple consumption-based asset pricing model by approximating the true asset pricing kernel using low-order orthonormal polynomials based on the model's state variables. Approximated kernels based solely on next period's consumption growth are not rejected by overall measures of model fit but they produce statistically and economically large pricing errors. Approximated kernels based on two quarters of future consumption growth and technology shocks have substantially improved overall fit. In particular, the best of these kernels are capable of eliminating the small firm effect. Copyright 1997 by American Finance Association.

This paper investigates the behavior of the term structure of interest rates over the business cycle. In contrast to the simple change in aggregate economic activity used in previous research, we use a more appropiate measure of the business cycle: the deviation of aggregate economic activity from its potentially stochastic trend. Stochastically detrending Gross Domestic Product (GDP) by Watson's [1986] UC-ARMA methodology significantly improves the term spread's informativeness regarding future economic activity. We also investigage the implications of the UC-ARIMA representation of aggregate consumption dynamics for a linear consumption based model of the term structure. The presence of an unobserved by independent cyclical component in aggregate consumption also allows for the more efficient estimation of consumption asset pricing models.