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Habit formation heterogeneity: Implications for aggregate asset pricing

Author

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  • Eduard Dubin
  • Olesya V. Grishchenko
  • Vasily Kartashov

Abstract

We study the asset pricing implications of a general equilibrium Lucas endowment economy inhabited by two agents with habit formation preferences. Preferences are modeled either as internal or external habits. We allow for agents' heterogeneity in relative risk aversion and habit strength. We explicitly compute aggregate prices, such as equity premium, equity volatility, Sharpe ratio, interest rate volatility, and asset holdings for both types of preferences. Equilibrium quantities are computed using a recently developed algorithm of Dumas and Lyasoff (2011), which is refined to capture time nonseparability induced by habit. We obtain that internal habits provide for a considerable improvement in obtaining aggregate asset pricing quantities consistent with historically observed magnitudes as opposed to ``catching up with Joneses" preferences.

Suggested Citation

  • Eduard Dubin & Olesya V. Grishchenko & Vasily Kartashov, 2012. "Habit formation heterogeneity: Implications for aggregate asset pricing," Finance and Economics Discussion Series 2012-07, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2012-07
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    References listed on IDEAS

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    1. Harjoat S. Bhamra & Raman Uppal, 2014. "Asset Prices with Heterogeneity in Preferences and Beliefs," Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 519-580.
    2. Grishchenko, Olesya V., 2010. "Internal vs. external habit formation: The relative importance for asset pricing," Journal of Economics and Business, Elsevier, vol. 62(3), pages 176-194, May.
    3. Qiang Dai & Olesya V. Grishchenko, 2014. "An Empirical Investigation of Consumption-Based Asset Pricing Models with Stochastic Habit Formation," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 4(01), pages 1-34.
    4. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    5. 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, September.
    6. Christian Heyerdahl-Larsen, 2014. "Asset Prices and Real Exchange Rates with Deep Habits," Review of Financial Studies, Society for Financial Studies, vol. 27(11), pages 3280-3317.
    7. Francisco Gomes & Alexander Michaelides, 2008. "Asset Pricing with Limited Risk Sharing and Heterogeneous Agents," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 415-448, January.
    8. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
    9. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," Econometrica, Econometric Society, vol. 77(6), pages 1711-1750, November.
    10. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
    11. Costas Xiouros & Fernando Zapatero, 2010. "The Representative Agent of an Economy with External Habit Formation and Heterogeneous Risk Aversion," Review of Financial Studies, Society for Financial Studies, vol. 23(8), pages 3017-3047, August.
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    Cited by:

    1. Curatola, Giuliano & Faia, Ester, 2016. "Divergent Risk-Attitudes and Endogenous Collateral Constraints," CEPR Discussion Papers 11678, C.E.P.R. Discussion Papers.

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