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Local Substitution and Habit Persistence: Matching the Moments of the Equity Premium and the Risk-Free Rate

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Author Info
Olivier Allais (CORELA-INRA)

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Abstract

This paper studies the empirical properties of introducing consumption complementarity and/or substitutability over time in a Lucas-style asset pricing model. Specifically, I investigate whether the model can replicate a selected set of observed U.S. asset return moments over the 1890-1999 period. Firstly, I find that local substitution substantially improves the habit persistence model's ability to fit the asset return moments. Secondly, combined effects of local substitution and long-run complementarity over consumption nearly explain the equity premium and the risk-free rate means and volatilities. I conclude that both habit persistence and local substitution are required to solve the standard financial empirical puzzles. However, these results imply slightly high values of relative risk aversion in consumption and in wealth. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2003.09.004
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Publisher Info
Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 7 (2004)
Issue (Month): 2 (April)
Pages: 265-296
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Handle: RePEc:red:issued:v:7:y:2004:i:2:p:265-296

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Related research
Keywords: Habit persistence and local substitution; equity premium; risk-free rate and volatility puzzles;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

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  3. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April. [Downloadable!] (restricted)
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  5. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 312-332, June. [Downloadable!]
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  6. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
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  7. repec:cup:macdyn:v:1:y:1997:i:2:p:312-32 is not listed on IDEAS
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  11. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity, Portfolio Choice, and Equilibrium Asset Returns," GSIA Working Papers 1997-45, Carnegie Mellon University, Tepper School of Business.
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  15. Duffie, Darrell & Singleton, Kenneth J, 1993. "Simulated Moments Estimation of Markov Models of Asset Prices," Econometrica, Econometric Society, vol. 61(4), pages 929-52, July. [Downloadable!] (restricted)
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  21. Cecchetti, Stephen G. & Lam, Pok-sang & Mark, Nelson C., 1993. "The equity premium and the risk-free rate : Matching the moments," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 21-45, February. [Downloadable!] (restricted)
    Other versions:
  22. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April. [Downloadable!] (restricted)
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  25. Hindy, Ayman & Huang, Chi-fu, 1992. "Intertemporal Preferences for Uncertain Consumption: A Continuous Time Approach," Econometrica, Econometric Society, vol. 60(4), pages 781-801, July. [Downloadable!] (restricted)
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  29. Eichenbaum, Martin & Hansen, Lars Peter, 1990. "Estimating Models with Intertemporal Substitution Using Aggregate Time Series Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 53-69, January.
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  30. Tauchen, George E. & Gallant, A. Ronald, 1995. "Which Moments to Match," Working Papers 95-20, Duke University, Department of Economics.
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    Other versions:
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Aase, Knut K., 2004. "Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles," Discussion Papers 2004/12, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
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