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Intertemporal Substitution and Equity Premium: A Perspective with Habit in Epstein-Zin Preferences

Wei Yang

Indiana University - Department of Finance

June 29, 2009

This paper presents a consumption based model that reveals intertemporal substitution as a distinctive and important channel, separate from risk aversion, in generating equity premium, return volatility, and their cyclical variations. Two main ingredients, Epstein-Zin preferences and external habit, allow the model to distinguish the separate effects of intertemporal substitution and risk aversion. The results indicate an effective elasticity of intertemporal substitution that is much lower than the parameter value and varies procyclically. On the other hand, the effective risk aversion is counter-cyclical and much higher than the parameter value. To match the empirical statistics of the post-war U.S. stock market, the model critically requires a small elasticity parameter below 1. This points to an interesting contrast between the habit formation and the long-run consumption risk models.

Number of Pages in PDF File: 42

Keywords: Habit formation, Epstein-Zin utility, equity premuim puzzle

JEL Classification: G12

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Date posted: March 21, 2008 ; Last revised: October 28, 2009

Suggested Citation

Yang, Wei, Intertemporal Substitution and Equity Premium: A Perspective with Habit in Epstein-Zin Preferences (June 29, 2009). Available at SSRN: http://ssrn.com/abstract=1107298 or http://dx.doi.org/10.2139/ssrn.1107298

Contact Information

Wei Yang (Contact Author)
Indiana University - Department of Finance ( email )
1309 E. 10th St.
Bloomington, IN 47405
United States
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References:  33
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