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

Athanasoulis, Stefano and Sussman, Oren (2007) Habit Formation and the Equity-Premium Puzzle: A Skeptical View. Annals of Finance, 3 (2). pp. 193-212.

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.

Item Type: Article
Keywords: Equity premium; Risk-free interest rate; Habit formation; finance
Subject(s): Finance
Date Deposited: 18 Feb 2012 20:52
Last Modified: 22 Feb 2017 15:31
Funders: N/A
URI: http://eureka.sbs.ox.ac.uk/id/eprint/2946

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