Abstract
We derive an explicit formula for the price-dividend ratio of a generalized version of Abel’s asset pricing model. This model is generalized in two ways: first, consumption (dividend) growth is assumed to be an AR(1) process subject to Gaussian random shocks, and second, the investor’s preferences are allowed to be a convex combination of internal and external habits. With an internal habit weight, 50%, and a coefficient of risk aversion, 3.25, simulation results match the historic US equity premium and risk free interest rate.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Abel A.B. (1990) Asset prices under habit formation and catching up with the jones. Am Econ Rev 80, 38–42
Abel A.B. (1999). Risk premia and term premia in general equilibrium. J Monetary Econ 43, 3–33
Bansal R., Yaron A. (2004) Risks for the long run: a potential resoluiton of asset pricing puzzles. J Financ 59, 1481–1510
Birdarkota P.V., McCulloch J.H. (2003) Consumption asset pricing with stable shocks—exploring a solution and its implications for mean equity returns. J Econ Dyn Control 27, 399–422
Bollerslev, T., Engle R.F., Nelson, D.B.: ARCH models. In: Engle, R.F., McFadden, D.L. (eds.) Handbook of econometrics, vol IV. Amsterdam: North Holland (1994)
Brock W. (1979) An integration of stochastic growth theory and the theory of finance, part I: the growth model. In: Green, J., Scheinkman J. (eds). General equilibrium, growth, and trade. New York, Academic, pp 165–192
Brock W. (1982). Asset prices in a production economy. In: McCall J. (ed). The economics of information and uncertainty. Chicago, University of Chicago Press, pp 1–43
Burnside C. (1998) Solving asset pricing models with gaussian shocks. J Econ Dyn Control 22, 329–340
Calin O.L., Chen Y., Cosimano T.F., Himonas A.A. (2005). Solving asset pricing models when the price-dividend function is analytic. Econometrica 73, 961–982
Campbell J.Y., Cochrane J. (1999). By force of habit, a consumption-based explanation of aggregate stock market behavior. J Polit Econ 107, 205–251
Campbell J.Y., Lo A.W., MacKinlay A.C. (1997). The econometrics of financial markets. Princeton: Princeton University Press
Campbell J.Y. (1986) Bond and stock returns in a simple exchange model. Q J Econ 101, 785–803
Cecchetti S.G., Lam P., Mark N. (2000) Asset prices with distorted beliefs: are equity returns too good to be true?. Am Econ Rev 90, 787–805
Chan, Y.L., Kogan, L.: Catching up with the joneses: heterogeneous preferences and the dynamics of asset prices, NBER working paper (2001)
Chen, X., Ludvigson, S.C.: Land of addicts? an empirical investigation of habit-based asset pricing models, NBER working paper (2004)
Collard F., Feve P., Ghattassi I. (2006) A note on the exact solution of asset pricing models with habit persistence. Macroecon Dyn 10, 273–283
Constantinides G.M. (2002) Rational asset prices. J Financ 62, 1567–1591
Easley D., O’Hara M. (2004) Information and the cost of capital. J Financ 59, 1553–1584
Folland G.B. (1984) Real analysis. New York, Wiley
Gali J. (1994) Keeping up with the joneses: consumption externalities, portfolio choice, and asset prices. J Money Credit Bank 26, 1–8
Jin H., Judd, K.: Perturbation methods for general dynamic stochastic models, Stanford University, working paper (2002)
Korniotis, G.M.: Estimating panel models with internal and external habit formation, Board of Governors of the Federal Reserve System working paper (2007)
Labadie P. (1989) Stochastic inflation and the equity premium. J Monetary Econ 24, 277–298
Lo A.W., Mamaysky H., Wang J. (2004) Asset pricing and trading volume under fixed transactions costs. J Polit Econ 112, 1054–1090
Mehra R., Prescott E.C. (1985) The equity premium: a puzzle. J Monetary Econ 15, 145–161
Mehra, R., Prescott, E.C.: The equity premium in retrospect. In: Constantinides, G.M., Harris, M., Stulz, R. (eds.) Handbook of the economics of finance. Amsterdam: North Holland (2003)
Merton R.C. (1990). Continuous-time finance. Oxford, Blackwell Publishers
Mood A.M., Graybill F.A., Boes D. (1974) Introduction to the theory of statistics, 3rd edn. New York, McGraw-Hill
Rosenburg J., Engle R.F. (2002) Empirical pricing kernels. J Financ Econ 64, 341–372
Samuelson P.A. (1970) The fundamental approximation theorem of portfolio analysus in terms of means, variance, and higher moments. Rev Econ Stud 37, 537–542
Schwert G.W. (1989). Why does stock market volatility change over time?. J Financ 64, 1115–1153
Schwert G.W. (1990). Indexes of U.S. stock prices from 1802–1987. J Business 63, 399–442
Shiller R.J. (1989). Market volatility. Cambridge, MIT Press
Tsionas E.G. (2003) Exact solution of asset pricing models with arbitrary shock distributions. J Econ Dyn Control 27, 843–851
Wachter J.A. (2006) A consumption model of the term structure of interest rates. J Financ Econ 79, 365–399
Wang J. (1994). A model of competitive stock trading volume. J Polit Econ 102, 127–168
Weil P. (1989). The equity premium puzzle and the risk-free rate puzzle. J Monetary Econ 24, 401–421
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Chen, Y., Cosimano, T.F. & Himonas, A.A. Solving an asset pricing model with hybrid internal and external habits, and autocorrelated Gaussian shocks. Annals of Finance 4, 305–344 (2008). https://doi.org/10.1007/s10436-007-0079-x
Received:
Revised:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10436-007-0079-x