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Term and Equity Premium in Economies with Habit Formation

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  • Santiago Budría
  • Antonia Díaz

Abstract

In this paper we analyze the equity, risk, and 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 FEDEA in its series Working Papers with number 2006-23.

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Date of creation: Oct 2006
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Handle: RePEc:fda:fdaddt:2006-23

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  1. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  2. Otrok, Christopher & Ravikumar, B. & Whiteman, Charles H., 2002. "Habit formation: a resolution of the equity premium puzzle?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(6), pages 1261-1288, September.
  3. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  4. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
  5. 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.
  6. 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.
  7. 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.
  8. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 51(2), pages 305-325, March.
  9. 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.
  10. Bennett T. McCallum, 1994. "Monetary Policy and the Term Structure of Interest Rates," NBER Working Papers 4938, National Bureau of Economic Research, Inc.
  11. Pijoan-Mas, Josep, 2006. "Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5602, C.E.P.R. Discussion Papers.
  12. 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.
  13. 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.
  14. 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.
  15. David K. Backus & Allan W. Gregory & Stanley E. Zin, 1986. "Risk Premiums in the Term Structure : Evidence from Artificial Economies," Working Papers, Queen's University, Department of Economics 665, Queen's University, Department of Economics.
  16. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Habit persistence and asset returns in an exchange economy," Working Paper Series, Macroeconomic Issues, Federal Reserve Bank of Chicago WP-97-04, Federal Reserve Bank of Chicago.
  17. 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.
  18. Federico Ravenna & University of California & Juha Seppala & University of Illinois, 2006. "Monetary Policy and the Term Structure of Interest Rates," Computing in Economics and Finance 2006, Society for Computational Economics 197, Society for Computational Economics.
  19. 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.
  20. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  21. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 341-355, June.
  22. 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.
  23. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  24. repec:cup:macdyn:v:6:y:2002:i:2:p:242-65 is not listed on IDEAS
  25. 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.
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