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Testing external habits in an asset pricing model

  • M Boschi

    ()

  • S d'Addona

    ()

  • A Goenka

    ()

The asset pricing model with external habit formation predicts that the equity premium depends on consumption changes relative to the habit level, implying a response that varies over the business cycle. We test this implication using a VAR model of the U.S. postwar economy whose time-varying parameters are estimated conditioning on Markov-switching regimes that shift according to the business cycle phases. This enables us to test whether the non-linear response predicted in the model is significant. The results show that the response of the equity premium to consumption shocks is insignificantly different over the business cycle. We interpret this as evidence against the external habit formation hypothesis.

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File URL: http://cama.crawford.anu.edu.au/pdf/working-papers/2012/202012.pdf
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Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2012-20.

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Length: 33 pages
Date of creation: May 2012
Date of revision:
Handle: RePEc:een:camaaa:2012-20
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