International Asset Pricing Under Habit Formation and Idiosyncratic Consumption Risk

56 Pages Posted: 14 Dec 2003  

Yuming Li

California State University

Maosen Zhong

University of Queensland - Business School

Abstract

This paper presents a consumption-based asset pricing model to explain the equity premium and riskfree puzzles as well as the predictability of returns in the international equity markets. We find that because the model entails idiosyncratic consumption risk which is higher than the aggregate consumption risk, the model helps lower the investor risk aversion needed to explain the mean equity premiums. In addition, because the model also allows for habit formation that disentangles intertemporal substitution from investor risk aversion, the model can resolve the riskfree rate puzzle. Further, as the timevarying individual investor risk aversion and the re-distribution of wealth among heterogeneous investors are contributing factors to the time-varying equity premiums, the model explains larger portions of the long-horizon predictability for many countries' equity markets and the world market portfolio than the world representative-agent model. In contrast, the power utility model with or without idiosyncratic consumption risk fails to explain the level of the real riskfree rate or the predictability of returns.

Keywords: international asset pricing, consumption-based model, habit formation

JEL Classification: G15, G12, D52

Suggested Citation

Li, Yuming and Zhong, Maosen, International Asset Pricing Under Habit Formation and Idiosyncratic Consumption Risk. AFA 2004 San Diego Meetings. Available at SSRN: https://ssrn.com/abstract=479561 or http://dx.doi.org/10.2139/ssrn.479561

Yuming Li (Contact Author)

California State University ( email )

School of Business Box 6848
Fullerton, CA 92834-9480
United States
714-278-2217 (Phone)
714-278-2161 (Fax)

Maosen Zhong

University of Queensland - Business School ( email )

Brisbane, Queensland 4072
Australia

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