A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-sectional Heterogeneity?

Fatih Guvenen

No 499, RCER Working Papers from University of Rochester - Center for Economic Research (RCER)

Abstract: In this paper we study the asset pricing implications of a parsimonious two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution. The parameter values for the model are taken from the real business cycle literature and are not calibrated to match any financial statistic. Yet, with a risk aversion of two, the model is able to explain a large number of asset pricing phenomena including all the facts matched by the external habit model of Campbell and Cochrane (1999). Examples in this list include a high equity premium and a low risk-free rate; a counter-cyclical risk premium, volatility and Sharpe ratio; predictable stock returns with coe?cients and R2 values of long-horizon regressions matching their empirical counterparts, among others. In addition the model generates a risk-free rate with low volatility (5.7 percent annually) and with high persistence. We also show that the similarity of our results to those from an external habit model is not a coincidence: the model has a reduced form representation which is extremely similar to Campbell and Cochrane’s framework for asset pricing. However, the macroeconomic implications of the two models are very different, favoring the limited participation model. Moreover, we show that policy analysis yields dramatically different conclusions in each framework.

Keywords: Limited stock market participation; asset pricing; the equity premium puzzle; incomplete markets; habit formation; elasticity of intertemporal substitution. (search for similar items in EconPapers)
JEL-codes: E32 E44 G12 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2003-03
New Economics Papers: this item is included in nep-cfn, nep-dge and nep-fin
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (38)

Downloads: (external link)
http://rcer.econ.rochester.edu/RCERPAPERS/rcer_499.pdf full text (application/pdf)
None

Related works:
Working Paper: A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation of Cross-sectional Heterogeneity? (2005)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:roc:rocher:499

Access Statistics for this paper

More papers in RCER Working Papers from University of Rochester - Center for Economic Research (RCER) University of Rochester, Center for Economic Research, Department of Economics, Harkness 231 Rochester, New York 14627 U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by Richard DiSalvo ( this e-mail address is bad, please contact ).