Loss Aversion, Habit Formation and the Term Structures of Equity and Interest Rates

34 Pages Posted: 17 Mar 2014

See all articles by Giuliano Curatola

Giuliano Curatola

University of Siena - Department of Economics and Statistics; Leibniz Institute for Financial Research SAFE

Date Written: March 15, 2014

Abstract

I propose a consumption-based asset pricing model that jointly explains the high equity premium, the counter-cyclical behaviour of stock returns, the upward sloping term structure of interest rates and the downward sloping term structure of equity. The driving forces behind these results are loss-aversion and time-varying habits. The high premium is the reward for holding assets that deliver low returns when consumption descends below habits. The term structure of interests rates is upward sloping because long-term bonds are more sensitive to fluctuations of discount rates. The term structure of equity is downward sloping because long-horizon equity gives higher chances to beat consumption habits than short-horizon equity.

Keywords: Loss-aversion, Habit Formation, Yield curve, Dividend strips, General Equilibrium.

JEL Classification: D51, D91, E20, G12

Suggested Citation

Curatola, Giuliano, Loss Aversion, Habit Formation and the Term Structures of Equity and Interest Rates (March 15, 2014). Available at SSRN: https://ssrn.com/abstract=2409588 or http://dx.doi.org/10.2139/ssrn.2409588

Giuliano Curatola (Contact Author)

University of Siena - Department of Economics and Statistics ( email )

Piazza San Francesco 7
Siena, Siena 53100
Italy

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

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