Working Paper: NBER ID: w12290
Authors: Andrew B. Abel
Abstract: I calculate exact expressions for risk premia, term premia, and the premium on levered equity in a framework that includes habit formation, keeping/catching up with the Joneses, and possible departures from rational expectations. Closed-form expressions for the first and second moments of returns and for the R2 of a regression of stock returns on the dividend-price ratio are derived under lognormality for the case that includes keeping/catching up with the Joneses. Linear approximations illustrate how these moments of returns are affected by parameter values and illustrate quantitatively how well the model can account for values of the equity premium, the term premium, and the standard deviations of the riskless return and the rate of return on levered equity. For empirically relevant parameter values, the linear approximations yield values of the various moments that are close to those obtained from the exact solutions.
Keywords: equity premium; risk premium; term premium; habit formation; consumption externalities
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Consumption benchmarks (E21) | Expected rates of return on assets (G19) |
| Habit formation and consumption externalities (D62) | Equity premium (G19) |
| Benchmark level of consumption (D12) | Pricing of equity assets (G19) |
| Dividend-price ratio (G35) | Stock returns (G12) |
| Subjective expectations and correlation between risky payoffs and pricing kernel (G19) | Risk premium (G19) |
| Deviations from rational expectations (D84) | Perceived risk of assets (G11) |