Habit Formation, Surplus Consumption and Return Predictability: International Evidence
Journal of International Money and Finance, Vol. 29, pp. 1237-1255, 2010
33 Pages Posted: 23 Jun 2008 Last revised: 14 May 2011
Date Written: December 17, 2009
On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.
Keywords: Habit formation, Campbell-Cochrane model, surplus consumption ratio, GMM estimation, pricing errors, return predictability
JEL Classification: E21, G12, G15
Suggested Citation: Suggested Citation