ELUCIDATING EQUITY PREMIUM USING CORPORATE DIVIDENDS AND HABIT FORMATION

Jow-Ran Chang and Hsu-Hsien Chu
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Jow-Ran Chang: Department of Quantitative Finance, National Tsing Hua University, 101, Sec. 2, Kuang-Fu Rd., Hsinchu, Taiwan
Hsu-Hsien Chu: #x2020;Institute of Technology Science Management, National Tsing Hua University, 101, Sec. 2, Kuang-Fu Rd., Hsinchu, Taiwan

Annals of Financial Economics (AFE), 2015, vol. 10, issue 02, 1-20

Abstract: This paper extends Longstaff and Piazzesi (2004, Journal of Financial Economics, 74, 401–421.) to a habit formation model. By combining corporate fraction ratio, and surplus consumption ratio, we derive closed-form solutions for stock values when dividends, habit ratio and consumption follow exponential affine jump-diffusion processes. We can prove that Longstaff and Piazzesi (2004) is only a special case of our model. In addition, calibrated results show that the corporate fraction and habit ratio to shocks significantly increases the equity premium and decreases the risk-free rate. The model determines realistic values for the equity premium and the risk-free rate.

Keywords: Dividends; equity premium puzzle; habit formation; risk-free rate puzzle (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1142/S2010495215500141

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