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An Empirical Investigation of Habit-Based Asset Pricing Models

Author

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  • Sydney C. Ludvigson
  • Xiaohong Chen

Abstract

A leading explanation of aggregate stock market behavior suggests that assets are priced as if there were a representative investor whose utility is a power function of the difference between aggregate consumption and a "habit" level, where the habit is some function of lagged and (possibly) contemporaneous consumption. But theory does not provide precise guidelines about the parametric functional relationship between the habit and aggregate consumption. This makes formal estimation and testing challenging; at the same time, it raises an empirical question about the functional form of the habit that best explains asset pricing data. This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. Our approach is to treat the functional form of the habit as unknown, and to estimate it along with the rest of the model's parameters. The resulting specification for investor utility is semiparametric in the sense that it contains both the finite dimensional set of unknown parameters that are part of the power function and time-preference, as well as the infinite dimensional unknown habit function that must be estimated nonparametrically. This semiparametric approach allows us to empirically evaluate a number of interesting hypotheses about the specification of habit-based asset pricing models, and to formally test the framework's ability to explain stock return data relative to other models that have proven empirically successful

Suggested Citation

  • Sydney C. Ludvigson & Xiaohong Chen, 2004. "An Empirical Investigation of Habit-Based Asset Pricing Models," Econometric Society 2004 North American Winter Meetings 332, Econometric Society.
  • Handle: RePEc:ecm:nawm04:332
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    Citations

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    Cited by:

    1. Cochrane, John H., 2005. "Financial Markets and the Real Economy," Foundations and Trends(R) in Finance, now publishers, vol. 1(1), pages 1-101, July.
    2. Alonso, Francisco & Blanco, Roberto & Rubio Irigoyen, Gonzalo, 2005. "Option-Implied Preferences Adjustments and Risk-Neutral Density Forecasts," DFAEII Working Papers 2005-10, University of the Basque Country - Department of Foundations of Economic Analysis II.
    3. Yu Chen & Thomas Cosimano & Alex Himonas, 2008. "Solving an asset pricing model with hybrid internal and external habits, and autocorrelated Gaussian shocks," Annals of Finance, Springer, vol. 4(3), pages 305-344, July.

    More about this item

    Keywords

    semi-nonparametric conditional moments; Habit-based asset pricing models;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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