Loss Aversion, Habit Formation and the Term Structures of Equity and Interest Rates
34 Pages Posted: 17 Mar 2014
Date Written: March 15, 2014
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: Suggested Citation