An Empirical Investigation of Consumption-Based Asset Pricing Models with Stochastic Habit Formation

41 Pages Posted: 11 Nov 2011 Last revised: 20 Aug 2012

See all articles by Qiang Dai

Qiang Dai

Braid Capital Pte Ltd.

Olesya V. Grishchenko

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: August 20, 2012

Abstract

We econometrically estimate a consumption-based asset pricing model with stochastic internal habit and test it using the generalized method of moments. The model departs from existing models with deterministic internal habit (e.g., Dunn and Singleton (1983), Ferson and Constantinides (1991), and Heaton (1995)) by introducing shocks to the coefficients in the distributed lag specification of consumption habit and consequently an additional shock to the marginal rate of substitution. The stochastic habit shocks proxied as labor income shocks are persistent and provide an additional source of time variation in expected returns. Using Treasury bond returns and broad equity market index returns, we show that stochastic internal habit formation models resolve the dichotomy between the autocorrelation properties of the stochastic discount factor and those of expected returns. Consequently, they provide a better explanation of time-variation in expected returns than models with either deterministic habit or stochastic external habit.

Keywords: consumption-based asset pricing models, habit formation, stochastic internal habit, aggregate equity and bond returns

JEL Classification: E21, G10, G12

Suggested Citation

Dai, Qiang and Grishchenko, Olesya V., An Empirical Investigation of Consumption-Based Asset Pricing Models with Stochastic Habit Formation (August 20, 2012). FEDS Working Paper No. 2011-47. Available at SSRN: https://ssrn.com/abstract=1957773 or http://dx.doi.org/10.2139/ssrn.1957773

Qiang Dai

Braid Capital Pte Ltd. ( email )

Singapore

Olesya V. Grishchenko (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2981 (Phone)

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