Output gap and consumption risk on the cross-section of stock returns in Korea

We examine if output gap can be the conditioning information for consumption-based asset pricing model in the Korean stock market. In an effort to empirically explain the cross-sectional variation of stock returns with economic equilibrium model, our conditioning variable, output gap, enables consumption capital asset pricing model (CCAPM) to explain a substantial variation in the cross-section of stock returns in Korea. In addition, the conditional version of CCAPM with output gap as a conditioning variable can explain the cross-section of stock returns about as well as the Fama-French three- and five-factor model when using future consumption growth. Asset's riskiness is determined by the correlation with consumption growth conditional on the business cycle measured by the output gap. (JEL G12).

Automated summary

This study examines the relationship between the output gap and the consumption-based asset pricing model in the Korean stock market. The results show that the output gap, as a conditioning variable, can explain a significant portion of the cross-sectional variation in stock returns in Korea. Furthermore, the conditional version of the consumption capital asset pricing model (CCAPM) with the output gap as a conditioning variable performs similarly to the Fama-French three- and five-factor models in explaining the cross-section of stock returns. The riskiness of an asset is determined by its correlation with consumption growth conditional on the business cycle, as measured by the output gap.