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Habit Formation and the Equity-Premium Puzzle: a Skeptical View

Author

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  • Stefano G. Athanasoulis
  • Oren Sussman
Abstract
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 afirst 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.

Suggested Citation

  • Stefano G. Athanasoulis & Oren Sussman, 2004. "Habit Formation and the Equity-Premium Puzzle: a Skeptical View," OFRC Working Papers Series 2004fe12, Oxford Financial Research Centre.
    • Handle: RePEc:sbs:wpsefe:2004fe12
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    File URL: http://www.finance.ox.ac.uk/file_links/finecon_papers/2004fe12.pdf
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    Cited by:

    1. Ravenna, Federico & Seppälä, Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Bank of Finland Research Discussion Papers 25/2006, Bank of Finland.
    2. repec:zbw:bofrdp:2006_025 is not listed on IDEAS
    3. Ravenna, Federico & Seppälä, Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Research Discussion Papers 25/2006, Bank of Finland.

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