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An empirical investigation of consumption-based asset pricing models with stochastic habit formation

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  • Qiang Dai
  • Olesya V. Grishchenko

Abstract

We econometrically estimate a consumption-based asset pricing model with stochastic internal habit and test it using the generalized method of moments. The model departs from existing models with deterministic internal habit (e.g., Dunn and Singleton (1983), Ferson and Constan- tinides (1991), and Heaton (1995)) by introducing shocks to the coefficients in the distributed lag specification of consumption habit and consequently an additional shock to the marginal rate of substitution. The stochastic shocks to the consumption habit are persistent and provide an additional source of time variation in expected returns. Using Treasury bond returns and broad equity market index returns, we show that stochastic internal habit formation models resolve the dichotomy between the autocorrelation properties of the stochastic discount factor and those of expected returns. Consequently, they provide a better explanation of time-variation in expected returns than models with either deterministic habit or stochastic external habit.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2011-47.

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Date of creation: 2011
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Handle: RePEc:fip:fedgfe:2011-47

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Keywords: Capital assets pricing model ; Stocks - Rate of return;

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References

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  1. Normandin, M. & St-Amour, P., 1996. "Substitution, Risk Aversion, Taste Shocks and Equity Premia," Papers 9606, Laval - Recherche en Politique Economique.
  2. Bekaert, Geert & Engstrom, Eric & Xing, Yuhang, 2009. "Risk, uncertainty, and asset prices," Journal of Financial Economics, Elsevier, vol. 91(1), pages 59-82, January.
  3. Stock, James H & Wright, Jonathan H & Yogo, Motohiro, 2002. "A Survey of Weak Instruments and Weak Identification in Generalized Method of Moments," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(4), pages 518-29, October.
  4. Tauchen, George E. & Gallant, A. Ronald, 1995. "Which Moments to Match," Working Papers 95-20, Duke University, Department of Economics.
  5. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  6. Grishchenko, Olesya V., 2010. "Internal vs. external habit formation: The relative importance for asset pricing," Journal of Economics and Business, Elsevier, vol. 62(3), pages 176-194, May.
  7. Andrea Buraschi & Alexei Jiltsov, 2007. "Habit Formation and Macroeconomic Models of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 62(6), pages 3009-3063, December.
  8. David A. Chapman, 1998. "Habit Formation and Aggregate Consumption," Econometrica, Econometric Society, vol. 66(5), pages 1223-1230, September.
  9. Yogo, Motohiro, 2008. "Asset Prices Under Habit Formation and Reference-Dependent Preferences," Journal of Business & Economic Statistics, American Statistical Association, vol. 26, pages 131-143, April.
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Cited by:
  1. Eduard Dubin & Olesya V. Grishchenko & Vasily Kartashov, 2012. "Habit formation heterogeneity: Implications for aggregate asset pricing," Finance and Economics Discussion Series 2012-07, Board of Governors of the Federal Reserve System (U.S.).

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