Habit Formation, Surplus Consumption and Return Predictability: International Evidence

Journal of International Money and Finance, Vol. 29, pp. 1237-1255, 2010

33 Pages Posted: 23 Jun 2008 Last revised: 14 May 2011

See all articles by Tom Engsted

Tom Engsted

University of Aarhus - CREATES

Stuart Hyde

University of Manchester - Manchester Business School

Stig Vinther Møller

Aarhus University - CREATES

Date Written: December 17, 2009

Abstract

On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.

Keywords: Habit formation, Campbell-Cochrane model, surplus consumption ratio, GMM estimation, pricing errors, return predictability

JEL Classification: E21, G12, G15

Suggested Citation

Engsted, Tom and Hyde, Stuart and Møller, Stig Vinther, Habit Formation, Surplus Consumption and Return Predictability: International Evidence (December 17, 2009). Journal of International Money and Finance, Vol. 29, pp. 1237-1255, 2010. Available at SSRN: https://ssrn.com/abstract=1150119 or http://dx.doi.org/10.2139/ssrn.1150119

Tom Engsted (Contact Author)

University of Aarhus - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Stuart Hyde

University of Manchester - Manchester Business School ( email )

Booth Street West
Mezzanine Floor, Crawford House
Manchester M15 6PB
United Kingdom
44 (0) 161 275 4017 (Phone)
44 (0) 161 275 4023 (Fax)

Stig Vinther Møller

Aarhus University - CREATES ( email )

Nordre Ringgade 1
Aarhus, DK-8000
Denmark

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