Human Capital and Asset Pricing

Abstract

From the optimal behavior of arbitrary number of consumer-investors who act as to maximize their life-time utility of consumption and leisure, this paper derives a continuous-time intertemporal asset pricing model with stochastic human capital, leisure, consumption, and investment opportunities. Explicit demand functions for assets are derived and it is shown that, with heterogeneous human capital, the classic fund separation results may no longer hold. The human capital is modeled to include not only its marketed benefits but also its non-market benefits by the use of aggregate labor income and three macro variables in labor statistics: the average weekly employment hours, the unemployment rate, and the labor participation rate. Three flexibility parameters are introduced to explicitly account for the hidden unemployment, the self-employment, and the time spent on job-related activity such as work-commute and so on. Although a formal and comprehensive test is left as a future research task, two pieces of evidence are provided. First, a quick revisit of the equity premium puzzle shows that my model is plausible to explain the observed equity premium with the actual data. Then a preliminary test using returns of the 25 Fama-French size B/M portfolios shows that my model captures about 75% of the total variation in the cross-section returns and that the unemployment rate plays a critical role in explaining the cross-section returns.