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Campbell and Cochrane meet Melino and Yang: reverse engineering the surplus ratio in a Mehra-Prescott economy

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  • Dolmas, James

Abstract

The habit model of Campbell and Cochrane (1999) specifies a process for the 'surplus ratio'-the excess of consumption over habit, relative to consumption-rather than an evolution for the habit stock. It's not immediately apparent if their formulation can be accommodated within the Markov chain framework of Mehra and Prescott (1985). This note illustrates one way to create a Campbell and Cochrane-like model within the Mehra-Prescott framework. A consequence is that we can perform another sort of reverse-engineering exercize-we can calibrate the resulting model to match the stochastic discount factor derived in the Mehra-Prescott framework by Melino and Yang (2003). The Melino-Yang SDF, combined with Mehra and Prescott's consumption process, yields asset returns that exactly match the first and second moments of the data, as estimated by Mehra and Prescott.> >

Suggested Citation

  • Dolmas, James, 2012. "Campbell and Cochrane meet Melino and Yang: reverse engineering the surplus ratio in a Mehra-Prescott economy," Working Papers 1205, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddwp:1205
    DOI: 10.24149/wp1205
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    File URL: http://www.dallasfed.org/assets/documents/research/papers/2012/wp1205.pdf
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Bryan R. Routledge & Stanley E. Zin, 2010. "Generalized Disappointment Aversion and Asset Prices," Journal of Finance, American Finance Association, vol. 65(4), pages 1303-1332, August.
    3. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
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    Keywords

    Financial markets; Asset pricing;

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