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Expected Returns and Habit Persistence

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  • Li, Yuming

Abstract

Using a consumption-based asset pricing model with infinite-horizon nonlinear habit formation, Campbell and Cochrane (1999) show that low consumption in surplus of habit should forecast high expected returns. This article argues that the finite-horizon linear habit model also implies an inverse relation between expected returns and surplus consumption. This article also presents empirical evidence, which indicates that expected returns on stocks and bonds vary with surplus consumption implied by the habit models. The volatility of returns and the reward to volatility are also related to surplus consumption. However, less than 30% of the predictable variation of expected returns, using standard lagged information variables, is attributed to surplus consumption. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Suggested Citation

  • Li, Yuming, 2001. "Expected Returns and Habit Persistence," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 861-899.
  • Handle: RePEc:oup:rfinst:v:14:y:2001:i:3:p:861-99
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    Cited by:

    1. Auer, Benjamin R., 2013. "Can habit formation under complete market integration explain the cross-section of international equity risk premia?," Review of Financial Economics, Elsevier, vol. 22(2), pages 61-67.
    2. Tano Santos & Pietro Veronesi, 2004. "Conditional Betas," NBER Working Papers 10413, National Bureau of Economic Research, Inc.
    3. Siddiqi, Hammad, 2015. "Anchoring and Adjustment Heuristic: A Unified Explanation for Equity Puzzles," MPRA Paper 68729, University Library of Munich, Germany.
    4. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
    5. Chrétien, Stéphane, 2012. "Bounds on the autocorrelation of admissible stochastic discount factors," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 1943-1962.
    6. George M. Constantinides, 2002. "Rational Asset Prices," Journal of Finance, American Finance Association, vol. 57(4), pages 1567-1591, August.
    7. Auer Benjamin R., 2012. "Lassen sich CAPM, HCAPM und CCAPM durch konsumbasierte zeitvariable Parameterspezifikation rehabilitieren? / Can Time-varying Parameter Specification Based on Consumption Variables Rehabilitate CAPM, ," Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), De Gruyter, vol. 232(5), pages 518-544, October.
    8. Charles Ka Yui Leung & Nan-Kuang Chen, 2006. "Intrinsic Cycles of Land Price: A Simple Model," Journal of Real Estate Research, American Real Estate Society, vol. 28(3), pages 293-320.
    9. Møller, Stig Vinther, 2009. "Habit persistence: Explaining cross-sectional variation in returns and time-varying expected returns," Journal of Empirical Finance, Elsevier, pages 525-536.
    10. Liu, Ludan, 2008. "It takes a model to beat a model: Volatility bounds," Journal of Empirical Finance, Elsevier, pages 80-110.
    11. Tano Santos & Pietro Veronesi, 2005. "Cash-Flow Risk, Discount Risk, and the Value Premium," NBER Working Papers 11816, National Bureau of Economic Research, Inc.
    12. Li, Jun & Yu, Jianfeng, 2012. "Investor attention, psychological anchors, and stock return predictability," Journal of Financial Economics, Elsevier, vol. 104(2), pages 401-419.
    13. Belén Nieto & Gonzalo Rubio, 2007. "Measuring time-varying economic fears with consumption-based stochastic discount factors," Economics Working Papers 1029, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2007.
    14. George M. Constantinides, 2006. "Market Organization And The Prices Of Financial Assets," Manchester School, University of Manchester, pages 1-23.
    15. Subrata Chakrabarty & Liang Wang, 2012. "The Long-Term Sustenance of Sustainability Practices in MNCs: A Dynamic Capabilities Perspective of the Role of R&D and Internationalization," Journal of Business Ethics, Springer, pages 205-217.
    16. Santos, Tano & Veronesi, Pietro, 2010. "Habit formation, the cross section of stock returns and the cash-flow risk puzzle," Journal of Financial Economics, Elsevier, vol. 98(2), pages 385-413, November.
    17. Wachter, Jessica A., 2005. "Solving models with external habit," Finance Research Letters, Elsevier, vol. 2(4), pages 210-226, December.
    18. Hyde, Stuart & Sherif, Mohamed, 2010. "Consumption asset pricing and the term structure," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(1), pages 99-109, February.
    19. Collard, Fabrice & Feve, Patrick & Ghattassi, Imen, 2006. "Predictability and habit persistence," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2217-2260, November.
    20. Li, Yuming & Zhong, Maosen, 2005. "Consumption habit and international stock returns," Journal of Banking & Finance, Elsevier, vol. 29(3), pages 579-601, March.
    21. Ludvigson, Sydney C., 2013. "Advances in Consumption-Based Asset Pricing: Empirical Tests," Handbook of the Economics of Finance, Elsevier.
    22. Madureira, Leonardo, 2007. "The ex ante real rate and inflation premium under a habit consumption model," Journal of Empirical Finance, Elsevier, pages 355-382.
    23. Engsted, Tom & Hyde, Stuart & Møller, Stig V., 2010. "Habit formation, surplus consumption and return predictability: International evidence," Journal of International Money and Finance, Elsevier, vol. 29(7), pages 1237-1255, November.

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