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Solving Models with External Habit

  • Jessica A. Wachter

Habit utility has been the focus of a large and growing body of literature in financial economics. This study investigates ways of accurately and efficiently solving the Campbell and Cochrane (1999) external habit model. Solutions for this model based on a grid of values for the state variable are shown to converge as the grid becomes increasingly fine. Convergence is substantially faster if the price-dividend ratio is computed as a series of ``zero-coupon equity'' claims rather than as the fixed-point of the Euler equation. Fitting the model to the term structure as well as to equity moments (as in Wachter (2005)) also results in faster convergence.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11559.

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Date of creation: Aug 2005
Date of revision:
Publication status: published as Wachter, Jessica A. "Solving Models With External Habit," Finance Research Letters, 2005, v2(4,Dec), 210-226.
Handle: RePEc:nbr:nberwo:11559
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