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

37 Pages Posted: 14 Dec 2005 Last revised: 29 Jan 2010

See all articles by Qiang Dai

Qiang Dai

University of North Carolina (UNC) at Chapel Hill - Finance Area

Olesya V. Grishchenko

Board of Governors of the Federal Reserve System

Date Written: January 26, 2010

Abstract

We econometrically estimate a consumption-based model asset pricing model with stochastic habit formation and test it using the generalized method of moments. The model departs from existing models with deterministic internal habit (e.g. Dunn and Singleton (1986), 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 shocks to the consumption habit 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 and 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 model, habit formation, stochastic habit, time-varying risk-premium

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 (January 26, 2010). Available at SSRN: https://ssrn.com/abstract=869405 or http://dx.doi.org/10.2139/ssrn.869405

Qiang Dai

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-7182 (Phone)

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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