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Term and Equity Premium in Economies with Habit Formation

Listed author(s):
  • Santiago Budría
  • Antonia Díaz

In this paper we analyze the equity, risk, and term premium in an representative agent exchange model economy where households preferences are subject to habit formation. As a novel feature, we develop theoretical measures for risk premium and term premium that can be used even when the consumption growth process is serially autocorrelated. We find that habit formation increases risk aversion significantly but increases much more the aversion to variations of consumption across dates. This induces a substantial increase in the precautionary demand of short term assets and a significant fall in the precautionary demand of long term assets. As a result, the term premium increases substantially with habit formation. Next we calibrate our model economy and examine the quantitative predictions of our theoretical measures of equity premium, risk premium and term premium. In line with previous literature, we show that it is possible to find a reasonable calibration for which the equity premium is that observed in the data. However, we find that around 70 percent of the equity premium is just term premium. That is, a very large fraction of the increase in the equity premium is due to the asymmetric effect that habit formation has on the precautionary demand of an asset depending on its maturity.

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Paper provided by FEDEA in its series Working Papers with number 2006-23.

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Date of creation: Oct 2006
Handle: RePEc:fda:fdaddt:2006-23
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  2. 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.
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  5. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 305-325, March.
  6. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  7. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  8. David A. Chapman, 2002. "Does Intrinsic Habit Formation Actually Resolve the Equity Premium Puzzle?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 618-645, July.
  9. repec:ner:carlos:info:hdl:10016/258 is not listed on IDEAS
  10. Federico Ravenna & University of California & Juha Seppala & University of Illinois, 2006. "Monetary Policy and the Term Structure of Interest Rates," Computing in Economics and Finance 2006 197, Society for Computational Economics.
  11. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
  12. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  13. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  14. Diaz, Antonia & Pijoan-Mas, Josep & Rios-Rull, Jose-Victor, 2003. "Precautionary savings and wealth distribution under habit formation preferences," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1257-1291, September.
  15. Lettau, Martin & Uhlig, Harald, 2002. "The Sharpe Ratio And Preferences: A Parametric Approach," Macroeconomic Dynamics, Cambridge University Press, vol. 6(02), pages 242-265, April.
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  18. Michele Boldrin & Lawrence J. Christiano & Jonas D. M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
  19. Lettau, M. & Uhlig, H.F.H.V.S., 1995. "Can Habit Formation be Reconciled with Business Cycle Facts?," Discussion Paper 1995-54, Tilburg University, Center for Economic Research.
  20. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  21. Josep Pijoan-Mas, 2007. "Pricing Risk in Economies with Heterogeneous Agents and Incomplete Markets," Journal of the European Economic Association, MIT Press, vol. 5(5), pages 987-1015, 09.
  22. Albert Marcet & Guido Lorenzoni, 1998. "Parameterized expectations approach; Some practical issues," Economics Working Papers 296, Department of Economics and Business, Universitat Pompeu Fabra.
  23. 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.
  24. Otrok, C. & Ravikumar, B. & Whiteman, C., 1998. "Habit Formation: A Resolution of the Equity Premium Puzzle?," Working Papers 98-04, University of Iowa, Department of Economics.
  25. repec:cup:macdyn:v:6:y:2002:i:2:p:242-65 is not listed on IDEAS
  26. Gruber, Joseph W., 2004. "A present value test of habits and the current account," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1495-1507, October.
  27. Albert Marcet & Guido Lorenzoni, 1998. "The Parameterized Expectations Approach: Some Practical Issues," QM&RBC Codes 128, Quantitative Macroeconomics & Real Business Cycles.
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