Testing Habits in an Asset Pricing Model

Abstract

We develop a model of asset pricing assuming that investor's behavior is habit forming. The model predicts that the effect of consumption growth shocks on the risk premium depends on the business cycle phase of the economy. This empirical implication is tested with a Markov-switching VAR model on the US postwar economy.

The results show that the response of the risk premium to shocks to consumption is not significantly different over the business cycle phases of the economy. We interpret this as evidence against the habit formation hypothesis of the investor's behavior.

Keywords: Habit formation, Equity premium, Business cycles, Markov-switching VAR models

JEL Classification: E21, E32, E44, G11, G12