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Local Substitution and Habit Persistence: Matching the Moments of the Equity Premium and the Risk-Free Rate

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  • Olivier Allais

    (CORELA-INRA)

Abstract
This paper studies the empirical properties of introducing consumption complementarity and/or substitutability over time in a Lucas-style asset pricing model. Specifically, I investigate whether the model can replicate a selected set of observed U.S. asset return moments over the 1890-1999 period. Firstly, I find that local substitution substantially improves the habit persistence model's ability to fit the asset return moments. Secondly, combined effects of local substitution and long-run complementarity over consumption nearly explain the equity premium and the risk-free rate means and volatilities. I conclude that both habit persistence and local substitution are required to solve the standard financial empirical puzzles. However, these results imply slightly high values of relative risk aversion in consumption and in wealth. (Copyright: Elsevier)

Suggested Citation

  • Olivier Allais, 2004. "Local Substitution and Habit Persistence: Matching the Moments of the Equity Premium and the Risk-Free Rate," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(2), pages 265-296, April.
    • Handle: RePEc:red:issued:v:7:y:2004:i:2:p:265-296
    DOI: 10.1016/j.red.2003.09.004
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    References listed on IDEAS

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    Cited by:

    1. Havranek, Tomas & Rusnak, Marek & Sokolova, Anna, 2017. "Habit formation in consumption: A meta-analysis," European Economic Review, Elsevier, vol. 95(C), pages 142-167.
    2. Aase, Knut K., 2004. "Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles," Discussion Papers 2004/12, Norwegian School of Economics, Department of Business and Management Science.
    3. Burkhard Heer & Alfred Maussner & Bernd Suessmuth, 2018. "Cyclical Asset Returns in the Consumption and Investment Goods Sector," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 28, pages 51-70, April.
    4. Collard, Fabrice & Feve, Patrick & Ghattassi, Imen, 2006. "Predictability and habit persistence," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2217-2260, November.
    5. Aase, Knut K. & Lillestøl, Jostein, 2015. "Beyond the local mean-variance analysis in continuous time: The problem of non-normality," Discussion Papers 2015/11, Norwegian School of Economics, Department of Business and Management Science.

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    More about this item

    Keywords

    Habit persistence and local substitution; equity premium; risk-free rate and volatility puzzles;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C83 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Survey Methods; Sampling Methods

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