Testing External Habits in an Asset Pricing Model

CAMA Working Papaer No. 20/2012

33 Pages Posted: 17 May 2012

See all articles by Melisso Boschi

Melisso Boschi

Centre for Applied Macroeconomic Analysis (CAMA)

Stefano d'Addona

University of Roma Tre

Aditya Goenka

affiliation not provided to SSRN

Date Written: May 2012

Abstract

The asset pricing model with external habit formation predicts that the equity premium depends on consumption changes relative to the habit level, implying a response that varies over the business cycle. We test this implication using a VAR model of the U.S. postwar economy whose time-varying parameters are estimated conditioning on Markov-switching regimes that shift according to the business cycle phases. This enables us to test whether the non-linear response predicted in the model is significant. The results show that the response of the equity premium to consumption shocks is insignificantly different over the business cycle. We interpret this as evidence against the external habit formation hypothesis.

Keywords: Habit formation, Equity premium, Business cycles, Markov-switching models,Time-varying VAR, Regime-dependent impulse response functions

JEL Classification: E21, E32, E44, G11, G12

Suggested Citation

Boschi, Melisso and d'Addona, Stefano and Goenka, Aditya, Testing External Habits in an Asset Pricing Model (May 2012). CAMA Working Papaer No. 20/2012, Available at SSRN: https://ssrn.com/abstract=2061462 or http://dx.doi.org/10.2139/ssrn.2061462

Melisso Boschi (Contact Author)

Centre for Applied Macroeconomic Analysis (CAMA) ( email )

ANU College of Business and Economics
Canberra, Australian Capital Territory 0200
Australia

Stefano D'Addona

University of Roma Tre ( email )

Via Chiabrera, 199
Rome, 00145
Italy

Aditya Goenka

affiliation not provided to SSRN ( email )

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