Consumption-Based Asset Pricing with Prospect Theory and Habit Formation

Jr-Yan Wang and Mao-Wei Hung

Chapter 48 in Handbook of Financial Econometrics, Mathematics, Statistics, and Machine Learning:(In 4 Volumes), 2020, pp 1789-1819 from World Scientific Publishing Co. Pte. Ltd.

Abstract: In this chapter, we propose a novel model to incorporate prospect theory into the consumption-based asset pricing model, where habit formation of consumption is employed to determine endogenously the reference point. Our model is motivated by the common element of prospect theory and habit formation of consumption that investors care little about the absolute level of wealth (consumption), but rather pay attention to gains or losses (excess or shortage in consumption level) compared to a reference point. The results show that if investors evaluate their excess or shortage amounts in consumption relative to their habit consumption levels based on prospect theory, the equity premium puzzle can be resolved.

Keywords: Financial Econometrics; Financial Mathematics; Financial Statistics; Financial Technology; Machine Learning; Covariance Regression; Cluster Effect; Option Bound; Dynamic Capital Budgeting; Big Data (search for similar items in EconPapers)
JEL-codes: C01 C1 G32 (search for similar items in EconPapers)
Date: 2020
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