By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior
We present a consumption-based model that explains the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. Our model has an i.i.d. consumption growth driving process, and adds a slow-moving external habit to the standard power utility function. The latter feature produces cyclical variation in risk aversion, and hence in the prices of risky assets. Our model also predicts many of the difficulties that beset the standard power utility model, including Euler equation rejections, no correlation between mean consumption growth and interest rates, very high estimates of risk aversion, and pricing errors that are larger than those of the static CAPM. Our model captures much of the history of stock prices, given only consumption data. Since our model captures the equity premium, it implies that fluctuations have important welfare costs. Unlike many habit-persistence models, our model does not necessarily produce cyclical variation in the risk free interest rate, nor does it produce an extremely skewed distribution or negative realizations of the marginal rate of substitution.
(This abstract was borrowed from another version of this item.)
|Date of creation:||Aug 1994|
|Date of revision:|
|Contact details of provider:|| Postal: 725 South Wells Street, Suite 800, Chicago, Illinois 60607-4501|
Web page: http://gsbwww.uchicago.edu/fac/finance/papers/
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:wop:chispw:412. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Thomas Krichel)
If references are entirely missing, you can add them using this form.