Local Substitution and Habit Persistence: Matching the Moments of the Equity Premium and the Risk-Free Rate

Olivier Allais ()

Review of Economic Dynamics, 2004, vol. 7, issue 2, 265-296

Abstract: This paper studies the empirical properties of introducing consumption complementarity and/or substitutability over time in a Lucas-style asset pricing model. Specifically, I investigate whether the model can replicate a selected set of observed U.S. asset return moments over the 1890-1999 period. Firstly, I find that local substitution substantially improves the habit persistence model's ability to fit the asset return moments. Secondly, combined effects of local substitution and long-run complementarity over consumption nearly explain the equity premium and the risk-free rate means and volatilities. I conclude that both habit persistence and local substitution are required to solve the standard financial empirical puzzles. However, these results imply slightly high values of relative risk aversion in consumption and in wealth. (Copyright: Elsevier)

Keywords: Habit persistence and local substitution; equity premium; risk-free rate and volatility puzzles (search for similar items in EconPapers)
JEL-codes: C83 G12 (search for similar items in EconPapers)
Date: 2004
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Citations: View citations in EconPapers (6)

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DOI: 10.1016/j.red.2003.09.004

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