A multifactor consumption based asset pricing model of the UK stock market: The US stock market as a wealth reference

Abstract

Here a multifactor model of UK stock returns is developed, replacing the conventional consumption habit reference by a relation that depends on US wealth. Two step Instrumental Variables and Generalized Method of Moments estimators are applied to reduce the impact of weak instruments. The standard errors are corrected for the generated regressor problem and the model is found to explain UK excess returns by UK consumption growth and expected US excess returns. Hence, controlling for nomina l effects by subtracting a risk free rate and conditioning on real US excess returns provides a coherent explanation of the equity premium puzzle.