The role of external habits and preference heterogeneity in the equity term structure

We investigate the role of habit formation in consumption and risk-aversion heterogeneity in determining the slope and volatility of the equity term structure. Our model generates a procyclical conditional slope and an unconditionally downward-sloping volatility of equity yields, both of which are consistent with empirical evidence. Using predictive regressions, we show that leverage—an observable proxy for risk-aversion heterogeneity—and a measure of habit consumption have significant predictive power for both the slope and volatility of the equity term structure. These findings highlight the importance of risk-aversion heterogeneity and habit formation in shaping the equity term structure and underscore their value as predictors of its dynamics.