Habit formation and the equity–premium puzzle: a skeptical view |
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Authors: | Stefano G. Athanasoulis Oren Sussman |
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Affiliation: | (1) Department of Finance, Mendoza College of Business, University of Notre Dame, Notre Dame, IN 46556-5646, USA;(2) Said Business School, University of Oxford, Park End Street, Oxford, OX1 1HP, England |
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Abstract: | We argue that, ceteris paribus, introducing a habit that resolves the equity–premium puzzle is equivalent to increasing the Arrow-Pratt coefficient of relative risk aversion, AP-RRA. If we constrain the AP-RRA to a constant ‘acceptable’ level, the effect on the equity premium is quantitatively insignificant. In a dynamic setting, the fluctuations of the habit increase the equity premium, slightly, though generates unrealistic fluctuations in the risk-free interest rate. We conclude a habit is observationally equivalent, up to a first-order approximation, to a higher AP-RRA and to a preference shock. These effects cannot resolve the equity–premium puzzle. |
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Keywords: | Equity premium Risk-free interest rate Habit formation |
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