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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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  • Olivier Allais

    (CORELA-INRA)

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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Bibliographic 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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References

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Cited by:
  1. Aase, Knut K., 2004. "Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles," Discussion Papers, Department of Business and Management Science, Norwegian School of Economics 2004/12, Department of Business and Management Science, Norwegian School of Economics.
  2. Collard, Fabrice & Fève, Patrick & Ghattassi, Imen, 2005. "Predictability and Habit Persistence," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 339, Institut d'Économie Industrielle (IDEI), Toulouse.

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