Habit Formation and the Equity-Premium Puzzle: a Skeptical View

Oren Sussman and Stefano G. Athanasoulis

No 2004-FE-12, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: We argue that ceteris paribus, introducing a habit that resolves the equity premium puzzle is equivalent to increasing the coefficient of relative risk aversion. Thus, if habit is modeled subject to the constraint that the Arrow-Pratt coefficient of relative risk aversion is held at a constant ‘acceptable’ level, the effect on the equity premium is not quantitatively significant. In a dynamic setting, the fluctuations of the habit increase the equity premium, slightly. However, modest improvement in the model’s predictive power comes at a cost of generating unrealistic fluctuations in the risk-free interest rate. Our analysis of these findings yields the following result: a habit is observationally equivalent,up to afirst order approximation, to a higher relative risk aversion and to a preference shock. Both these effects are known to be insufficient for resolving the equity-premium puzzle.

Keywords: equity premium; risk-free interest rate; habit formation (search for similar items in EconPapers)
JEL-codes: G0 G1 (search for similar items in EconPapers)
Date: 2004-06-01
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Citations: View citations in EconPapers (2)

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