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Habit persistence: Explaining cross-sectional variation in returns and time-varying expected returns

This paper finds empirical support for the habit persistence model of Campbell and Cochrane (1999) along both cross-sectional and time-series dimensions of the US stock market over the period 1947-2005. GMM estimations show that the model is able to explain a substantial part of the cross-sectional variation in returns on the 25 Fama and French value and size portfolios, although it has difficulties in fully explaining the value premium. In addition, the model accounts for time-varying expected returns on stocks. The surplus consumption ratio forecasts future stock returns and the forecasting power is not diminished by including the 1990s stock market boom. The extended version of the model allows for cyclical variation in interest rates and provides a reasonable fit of the real risk free rate.

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Paper provided by University of Aarhus, Aarhus School of Business, Department of Business Studies in its series Finance Research Group Working Papers with number F-2008-04.

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Length: 31 pages
Date of creation: 19 Mar 2008
Date of revision:
Handle: RePEc:hhb:aarbfi:2008-04
Contact details of provider: Postal: The Aarhus School of Business, Fuglesangs Allé 4, DK-8210 Aarhus V, Denmark
Fax: + 45 86 15 19 43
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  1. Li, Yuming, 2005. "The Wealth-Consumption Ratio and the Consumption-Habit Ratio," Journal of Business & Economic Statistics, American Statistical Association, vol. 23, pages 226-241, April.
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  10. Lettau, Martin & Wachter, Jessica, 2005. "Why is Long-Horizon Equity Less Risky? A Duration-based Explanation of the Value Premium," CEPR Discussion Papers 4921, C.E.P.R. Discussion Papers.
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  12. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
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  15. Kothari, S. P. & Shanken, Jay, 1997. "Book-to-market, dividend yield, and expected market returns: A time-series analysis," Journal of Financial Economics, Elsevier, vol. 44(2), pages 169-203, May.
  16. Martin Lettau & Sydney Ludvigson, 1999. "Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying," Staff Reports 93, Federal Reserve Bank of New York.
  17. Martin Lettau, 2001. "Consumption, Aggregate Wealth, and Expected Stock Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 815-849, 06.
  18. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  19. Andrew Ang & Geert Bekaert, 2004. "The term structure of real rates and expected inflation," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  20. Stuart Hyde & Mohamed Sherif, 2005. "Consumption Asset Pricing Models: Evidence From The Uk," Manchester School, University of Manchester, vol. 73(3), pages 343-363, 06.
  21. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  22. Bekaert, Geert & Engstrom, Eric & Grenadier, Steven R., 2010. "Stock and bond returns with Moody Investors," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 867-894, December.
  23. Wachter, Jessica A., 2005. "Solving models with external habit," Finance Research Letters, Elsevier, vol. 2(4), pages 210-226, December.
  24. Li, Yuming, 2001. "Expected Returns and Habit Persistence," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 861-99.
  25. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  26. Lewellen, Jonathan & Nagel, Stefan & Shanken, Jay, 2010. "A skeptical appraisal of asset pricing tests," Journal of Financial Economics, Elsevier, vol. 96(2), pages 175-194, May.
  27. Jonathan A. Parker & Christian Julliard, 2005. "Consumption Risk and the Cross Section of Expected Returns," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 185-222, February.
  28. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  29. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887 Elsevier.
  30. Andrea Buraschi & Alexei Jiltsov, 2007. "Habit Formation and Macroeconomic Models of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 62(6), pages 3009-3063, December.
  31. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
  32. Stuart Hyde & Keith Cuthbertson & Dirk Nitzsche, 2005. "Resuscitating the C-CAPM: empirical evidence from France and Germany," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 10(4), pages 337-357.
  33. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  34. Lars Ljungqvist & Harald Uhlig, 2009. "Optimal Endowment Destruction under Campbell-Cochrane Habit Formation," NBER Working Papers 14772, National Bureau of Economic Research, Inc.
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