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Habit Formation: A Resolution of the Equity Premium Puzzle?

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Author Info

  • Otrok, C.

    ()
    (University of Iowa)

  • Ravikumar, B.

    ()
    (University of Iowa)

  • Whiteman, C.

    ()
    (University of Iowa)

Abstract

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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Bibliographic Info

Paper provided by University of Iowa, Department of Economics in its series Working Papers with number 98-04.

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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://tippie.uiowa.edu/economics/
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Related research

Keywords: Habit Formation; Equity Premium; Spectral Utility;

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References

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  1. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  2. Backus, David K & Gregory, Allan W & Telmer, Chris I, 1993. " Accounting for Forward Rates in Markets for Foreign Currency," Journal of Finance, American Finance Association, vol. 48(5), pages 1887-1908, December.
  3. Taub, Bart, 1989. "Dynamic consistency of insurance contracts under enforcement by exclusion," Journal of Economic Dynamics and Control, Elsevier, vol. 13(1), pages 93-112, January.
  4. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  5. Harald Uhlig & Lars Ljungqvist, 2000. "Tax Policy and Aggregate Demand Management under Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 90(3), pages 356-366, June.
  6. Narayana R. Kocherlakota, 1996. "The Equity Premium: It's Still a Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(1), pages 42-71, March.
  7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  8. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  9. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Habit persistence and asset returns in an exchange economy," Working Paper Series, Macroeconomic Issues WP-97-04, Federal Reserve Bank of Chicago.
  10. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  11. Bansal, Ravi & Coleman, Wilbur John, II, 1996. "A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1135-71, December.
  12. Whiteman, Charles H., 1985. "Spectral utility, wiener-hopf techniques, and rational expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 9(2), pages 225-240, October.
  13. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  14. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  15. Whiteman, Charles H, 1986. "An Analytical Policy Design under Rational Expectations," Econometrica, Econometric Society, vol. 54(6), pages 1387-1405, November.
  16. Barro, Robert J & King, Robert G, 1984. "Time-separable Preferences and Intertemporal-Substitution Models of Business Cycles," The Quarterly Journal of Economics, MIT Press, vol. 99(4), pages 817-39, November.
  17. Otrok, Christopher, 2001. "Spectral Welfare Cost Functions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(2), pages 345-67, May.
  18. Heaton, John, 1995. "An Empirical Investigation of Asset Pricing with Temporally Dependent Preference Specifications," Econometrica, Econometric Society, vol. 63(3), pages 681-717, May.
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