Habit Formation and the Cross Section of Stock Returns
74 Pages Posted: 15 Dec 2001
Date Written: December 12, 2001
We develop an external habit persistence model where the time series of the aggregate portfolio and the cross section of stock returns are simultaneously studied and tested. By applying a slightly modified version of the model of Campbell and Cochrane (1999), we obtain closed form solutions for individual securities prices and returns and a full characterizations of the dynamics of the risk-return characteristics of individual securities. We find that each stock return "beta" with respect to the total wealth portfolios is jointly determined by an aggregate variable that depends on the habit level, and an idiosyncratic asset characteristics that depends on the contribution of the security to total consumption relative to its long-run average contribution. This functional form imposes tight predictions on the cross sectional test, including sign and magnitude of the coefficients, and insures that the explanatory power of the beta comes from the predictable part of the realization of returns. An estimate of the model for a set of 20 industry portfolios is able to explain cross-sectional variation in the conditional expected returns. Moreover, the model generates price consumption ratios for individual industries that track well the empirical ones.
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