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ABSTRACT

This paper investigates the importance of idiosyncratic consumption risk for the cross-sectional variation in asset returns. We find that besides the rate of aggregate consumption growth, the cross-sectional variance of consumption growth is also a priced factor. This suggests that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns reflect their attempts to reduce their exposure to this risk. The resulting two-factor consumption-based asset pricing model significantly outperforms the CAPM, and its performance compares favorably with that of the Fama–French three-factor model.