Athanasoulis, Stefano and Sussman, Oren (2007) Habit Formation and the Equity-Premium Puzzle: A Skeptical View. Annals of Finance, 3 (2). pp. 193-212.
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.
|Keywords:||Equity premium; Risk-free interest rate; Habit formation|
|Centre:||Faculty of Finance|
|Date Deposited:||18 Feb 2012 20:52|
|Last Modified:||23 Oct 2015 14:07|
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