Tests of the Conditional Asset Pricing Model : Further Evidence from the Cross-Section of Stock Returns

We investigate the relationship between consumption and the term structure using U.K. interest rate data. We demonstrate that the term structure contains information about future economic activity as implied by the benchmark time separable power utility consumption based capital asset pricing model (C-CAPM) since the yield spread has forecasting power for future consumption growth. Further, we analyze the ability of this benchmark and two alternative models which adopt utility functions characterized by non-separability, namely, the extension to the habit formation model of Campbell and Cochrane (1999) proposed by Wachter (2006) and the housing C-CAPM proposed by Piazzesi et al. (2007). Our findings are supportive of the habit formation specification of Wachter (2006), other models fail to yield economically plausible parameter values