Working Paper: NBER ID: w10503
Authors: Xiaohong Chen; Sydney C. Ludvigson
Abstract: This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. We treat the functional form of the habit as unknown, and to estimate it along with the rest of the model's finite dimensional parameters. Using quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, the habit formation is better described as internal rather than external, and the estimated time-preference parameter and the power utility parameter are sensible. In addition, the estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross-sectional stock return data . We find that an internal habit SDF proxy can explain a cross-section of size and book-market sorted portfolio equity returns better than (i) the Fama and French (1993) three-factor model, (ii) Lettau and Ludvigson (2001) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM.
Keywords: habit formation; asset pricing; stochastic discount factor
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| habit function (D11) | SDF (C69) |
| internal habit formation (D10) | explanation of cross-sectional stock return data (G12) |
| internal habit model (C59) | specification error (C20) |