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Term Premium And Equity Premium In Economies With Habit Formation

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  • Santiago Budria
  • Antonia Diaz

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Abstract

In this paper we investigate the size of the risk premium and the term premium in an representative agent exchange model economy where households preferences are subject to habit formation. As a novel feature, we develop theoretical measures for risk premium and term premium that can be used even when the consumption growth process is serially autocorrelated. We find that habit formation increases risk aversion significantly but increases much more the aversion to variations of consumption across dates. This induces a substantial increase in the precautionary demand of short term assets and a significant fall in the precautionary demand of long term assets. As a result, the term premium increases substantially with habit formation. Next we calibrate our model economy and examine the quantitative predictions of our theoretical measures of equity premium, risk premium and term premium. In line with previous literature, we show that it is possible to find a reasonable calibration for which the equity premium is that observed in the data. However, we find that around 70 percent of the equity premium is just term premium. That is, a very large fraction of the increase in the equity premium is due to the asymmetric effect that habit formation has on the precautionary demand of an asset depending on its maturity.

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Bibliographic Info

Paper provided by Universidad Carlos III, Departamento de Economía in its series Economics Working Papers with number we065522.

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Date of creation: Sep 2006
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Handle: RePEc:cte:werepe:we065522

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  1. Michele Boldrin & Lawrence J. Christiano & Jonas D. M. Fisher, 2000. "Habit persistence, asset returns and the business cycle," Staff Report, Federal Reserve Bank of Minneapolis 280, Federal Reserve Bank of Minneapolis.
  2. Lettau, M. & Uhlig, H., 1995. "Can Habit Formation be Reconciled with Business Cycle Facts?," Discussion Paper, Tilburg University, Center for Economic Research 1995-54, Tilburg University, Center for Economic Research.
  3. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, American Economic Association, vol. 80(2), pages 38-42, May.
  4. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers, University of Iowa, Department of Economics 95-05, University of Iowa, Department of Economics.
  5. Josep Pijoan-Mas 2 & Antonia Díaz & José-Víctor Ríos-Rull, 2001. "Habit Formation: Inplications For The Wealth Distribution," Economics Working Papers, Universidad Carlos III, Departamento de Economía we015114, Universidad Carlos III, Departamento de Economía.
  6. Josep Pijoan-Mas, 2002. "Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets," Centro de Alti­simos Estudios Ri­os Pe©rez(CAERP), Centro de Altisimos Estudios Rios Perez (CAERP) 3, Centro de Altisimos Estudios Rios Perez (CAERP).
  7. Otrok, C. & Ravikumar, B. & Whiteman, C., 1998. "Habit Formation: A Resolution of the Equity Premium Puzzle?," Working Papers, University of Iowa, Department of Economics 98-04, University of Iowa, Department of Economics.
  8. Jeffery D. Amato & Thomas Laubach, 2001. "Implications of habit formation for optimal monetary policy," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2001-58, Board of Governors of the Federal Reserve System (U.S.).
  9. David A. Chapman, 2002. "Does Intrinsic Habit Formation Actually Resolve the Equity Premium Puzzle?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 618-645, July.
  10. Albert Marcet & Guido Lorenzoni, 1998. "Parameterized expectations approach; Some practical issues," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 296, Department of Economics and Business, Universitat Pompeu Fabra.
  11. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  12. Juha Seppala & Federico Ravenna, 2005. "Monetary Policy and the Term Structure of Interest Rates," 2005 Meeting Papers, Society for Economic Dynamics 804, Society for Economic Dynamics.
  13. Bennett T. McCallum, 1994. "Monetary Policy and the Term Structure of Interest Rates," NBER Working Papers 4938, National Bureau of Economic Research, Inc.
  14. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  15. Ryder, Harl E, Jr & Heal, Geoffrey M, 1973. "Optimum Growth with Intertemporally Dependent Preferences," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 40(1), pages 1-33, January.
  16. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 95-42, Board of Governors of the Federal Reserve System (U.S.).
  17. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 1(02), pages 312-332, June.
  18. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(3), pages 519-43, June.
  19. Lettau, Martin & Uhlig, Harald, 2002. "The Sharpe Ratio And Preferences: A Parametric Approach," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 6(02), pages 242-265, April.
  20. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 367-390, June.
  21. Gruber, Joseph W., 2004. "A present value test of habits and the current account," Journal of Monetary Economics, Elsevier, Elsevier, vol. 51(7), pages 1495-1507, October.
  22. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(3), pages 371-399, November.
  23. Albert Marcet & Guido Lorenzoni, 1998. "The Parameterized Expectations Approach: Some Practical Issues," QM&RBC Codes, Quantitative Macroeconomics & Real Business Cycles 128, Quantitative Macroeconomics & Real Business Cycles.
  24. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  25. repec:cup:macdyn:v:6:y:2002:i:2:p:242-65 is not listed on IDEAS
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