Revisiting asset pricing under habit formation in an overlapping-generations economy (original) (raw)
Related papers
Habit formation in an overlapping generations model with borrowing constraints
2011
We introduce habit-formation in the three-period OLG borrowing-constrained framework of Constantinides et al. (2002) by allowing the utility of the middleaged (old) to depend on consumption when young (middle-aged). This specification enables us to separate the effect of the two habit parameters (middle-aged and old) since each representative age-group can face different levels of habit persistence. The two-habit setup underlines some important issues with regards to savings and security returns which do not always conform to the standard findings in the literature. In addition, the model produces equity premium consistent with US data for relatively small levels of risk aversion. We are grateful to John Donaldson for numerous comments and suggestions during the course of this research. We are especially thankful to the editor, John Doukas, and George Constantinides, the referee, for their various helpful comments and suggestions.
Habit formation: a resolution of the equity premium puzzle?
Journal of Monetary Economics, 2002
We explore how the introduction of habit preferences into the simple intertemporal consumption-based capital asset pricing model "solves" the equity premium and risk-free rate puzzles. While agents with time-separable preferences care only about the overall volatility of consumption, we show that agents with habit preferences care not only about overall volatility, but also about the temporal distribution of that volatility. Specifically, habit agents are much more averse to high-frequency fluctuations than to low-frequency fluctuations. In fact, the size of the equity premium in the habit model is determined by a relatively insignificant amount of high-frequency volatility in U.S. consumption. Further, the model's premium and returns are very sensitive to changes in characteristics of the stochastic process for consumption, changes that have been dramatic during the 20 th century. The model also carries counterfactual implications for the equally dramatic changes in the equity premium and risk-free rate observed over the last 100 years.
Age-Dependent Increasing Risk Aversion and the Equity Premium Puzzle
Financial Review, 2019
We introduce a new preference structure-age-dependent increasing risk aversion (IRA)-in a three-period overlapping generations model with borrowing constraints, and examine the behavior of equity premium in this framework. We find that IRA preferences generate results that are more consistent with U.S. data for the equity premium, level of savings and portfolio shares, without assuming unreasonable levels of risk aversion. We find that the relative difference between the two risk aversions (how much more risk-averse old agents are relative to the middle-aged) matters more than the average risk aversion in the economy (how much more risk-averse both cohorts are). Our findings are robust with respect to a number of model generalizations.
Review of Economic Dynamics, 2003
Motivated by the success of internal habit formation preferences in explaining asset pricing puzzles, we introduce these preferences in a life-cycle model of consumption and portfolio choice with liquidity constraints, undiversifiable labor income risk and stock-market participation costs. In contrast to the initial motivation, we find that the model is not able to simultaneously match two very important stylized facts: a low stock market participation rate, and moderate equity holdings for those households that do invest in stocks. Habit formation increases wealth accumulation because the intertemporal consumption smoothing motive is stronger. As a result, households start participating in the stock market very early in life, and invest their portfolios almost fully in stocks. Therefore, we conclude that, with respect to its ability to match the empirical evidence on asset allocation behavior, the internal habit formation model is dominated by its time-separable utility counterpart.
Habit formation and the equity–premium puzzle: a skeptical view
Annals of Finance, 2006
We argue that ceteris paribus, introducing a habit that resolves the equity premium puzzle is equivalent to increasing the coefficient of relative risk aversion. Thus, if habit is modeled subject to the constraint that the Arrow-Pratt coefficient of relative risk aversion is held at a constant 'acceptable' level, the effect on the equity premium is not quantitatively significant. In a dynamic setting, the fluctuations of the habit increase the equity premium, slightly. However, modest improvement in the model's predictive power comes at a cost of generating unrealistic fluctuations in the risk-free interest rate. Our analysis of these findings yields the following result: a habit is observationally equivalent, up to a first order approximation, to a higher relative risk aversion and to a preference shock. Both these effects are known to be insufficient for resolving the equity-premium puzzle.
Term premium and equity premium in economies with habit formation
2006
In this paper we investigate the size of the risk premium and the term premium in an representative agent exchange model economy where households preferences are subject to habit formation. As a novel feature, we develop theoretical measures for risk premium and term premium that can be used even when the consumption growth process is serially autocorrelated. We find that habit formation increases risk aversion significantly but increases much more the aversion to variations of consumption across dates. This induces a substantial increase in the precautionary demand of short term assets and a significant fall in the precautionary demand of long term assets. As a result, the term premium increases substantially with habit formation. Next we calibrate our model economy and examine the quantitative predictions of our theoretical measures of equity premium, risk premium and term premium. In line with previous literature, we show that it is possible to find a reasonable calibration for w...
Preferences, consumption smoothing, and risk premia
1997
Risk premia in the consumption capital asset pricing model depend on preferences and dividend. We develop a decomposition which allows a separate treatment of both components. We show that preferences alone determine the risk-return tradeoff measured by the Sharpe-ratio. In general, the risk-return trade-off implied by preferences depends on the elasticity of a preference-based stochastic discount factor for pricing assets with respect to the consumption innovation. Depending on the particular specification of preferences, the absolute value of this elasticity can coincide to the inverse of the elasticity of intertemporal substitution (e.g. for habit formation preferences) or the coefficient of relative risk-aversion (e.g. for Epstein-Zin preferences). We demonstrate that preferences based on a small elasticity of intertemporal substitution, such as habit formation, produce small risk premia once agents are allowed to save. Departing from the complete markets framework, we show that uninsurable risk can only increase the Sharpe-ratio and risk premia if dividends are correlated with individual consumption.
Age-Dependent Increasing Risk Aversion and Asset Price Puzzles
2018
We introduce a new preference structure–age-dependent increasing risk aversion (IRA)–in a three-period overlapping generations model with borrowing constraints, and examine the behavior of equity premium in this framework. We find that IRA preferences generate results that are more consistent with U.S. data for the equity premium, level of savings and portfolio shares, without assuming unreasonable levels of risk aversion. We find that the relative difference between the two risk aversions (how much more risk-averse old agents are relative to the middle-aged) matters more than the average risk aversion in the economy (how much more risk averse both cohorts are). Our findings are robust with respect to a number of model generalizations. JEL Classification: G0, G12, D10, E21.
Consumption Habit and Equity Premium in the G7 Countries
2000
The consumption capital asset pricing model (C-CAPM) fails to explain the observed equity premia apart from considering implausible values of the risk aversion coefficient. This equity premium puzzle has been attributed in particular to the time-separability of the consumers' preferences. This paper investigates empirically the ability of the C-CAPM to solve this puzzle once assumed that consumption behaviour presents habit
Borrowing Costs and the Demand for Equity over the Life Cycle
Review of Economics and Statistics, 2006
We analyze consumption and portfolio behavior in a life-cycle model with realistic borrowing costs and income processes. We show that even a small wedge between borrowing costs and the risk-free return dramatically shrinks the demand for equity. When the cost of borrowing equals or exceeds the expected return on equity -the relevant case according to the data -households hold little or no equity during much of the life cycle. The model also implies that the correlation between consumption growth and equity returns is low at all ages, and that risk aversion estimates based on the standard excess return formulation of the consumption Euler Equation are greatly upward biased. The demand for equity in the model is non-monotonic in borrowing costs and risk aversion, and the standard deviation of marginal utility growth is an order of magnitude smaller than the Sharpe ratio.