We explore how the introduction of habit preferences into the simple intertemporal consumption-based capital asset pricing model "solves" the equity premium and risk-free rate puzzles. Our exploration employs spectral utility functions that decompose agents' preferences for consumption smoothness into preferences for smoothness by frequency. While agents with time-separable preferences care only about the overall volatility of consumption, we show that agents with habit preferences care not only about overall volatility, but also about the temporal distribution of that volatility. Specifically, habit agents are much more averse to high-frequency fluctuations than to low-frequency fluctuations. In fact, the size of the equity premium in the habit model is determined by a relatively insignificant amount of high-frequency volatility in U.S. consumption. Further, the model's premia and returns are very sensitive to changes in characteristics of the stochastic process for consumption, changes that have been dramatic during the 20th century. The model also carries counterfactual implications for the equally dramatic changes in the equity premium and risk-free rate observed over the last 100 years.
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Paper provided by University of Iowa, Department of Economics in its series Working Papers with number
98-04.
Length: 23 Pages Date of creation: May 1998 Date of revision: Handle: RePEc:uia:iowaec:98-04
Contact details of provider: Postal: University of Iowa, Department of Economics, Henry B. Tippie College of Business, Iowa City, Iowa 52242 Phone: (319) 335-0829 Fax: (319) 335-1956 Web page: http://www.biz.uiowa.edu/econ/ More information through EDIRC
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Find related papers by JEL classification: G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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