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Testing external habits in an asset pricing model

Melisso Boschi (), Stefano-Hung d'Addona and Aditya Goenka ()
Additional contact information
Stefano-Hung d'Addona: University of Rome 3
Aditya Goenka: University of Birmingham

Discussion Papers from Department of Economics, University of Birmingham

Abstract: A class of asset pricing models with external habit formation imply a nonlinear relationship between the counter-cyclical equity premium and the surplus consumption over the business cycle. The effect of a shock to surplus consumption on the equity premium will be asymmetric in a boom versus a recession. We test this using a novel approach to the estimation of a time-varying VAR model of the U.S. postwar economy where parameters are conditional on Markov-switching regimes associated to the business cycle phases. We estimate the regime-dependent impulse response functions and show that the equity premium increases following a negative shock to the surplus consumption either in boom or in recession. The response in recession is significantly larger than in boom. These results provide evidence in favor of the external habit formation hypothesis.

Keywords: Habit formation; Equity premium; Business cycle; Markov-switching models; Time-varying VAR; Regime-dependent impulse response functions (search for similar items in EconPapers)
JEL-codes: E21 E32 E44 G11 G12 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2021-06
New Economics Papers: this item is included in nep-fmk, nep-mac and nep-ore
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Working Paper: Testing external habits in an asset pricing model (2012) Downloads
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