An Empirical Investigation of Consumption-Based Asset Pricing Models with Stochastic Habit Formation
Quarterly Journal of Finance
A consumption-based asset pricing model with stochastic habit formation is econometrically estimated and tested using generalized method of moments. The model departs from existing models with deterministic internal habit (e.g., Dunn and Singleton (1986) , Ferson and Constantinides (1991) , and Heaton (1995)) by introducing shocks to the coefficients in the distributed lag specification of consumption habit and consequently an additional shock to the marginal rate of substitution. The
... shocks to the consumption habit are persistent and provide an additional source of time-variation in expected returns. Using Treasury bond returns and broad equity market index returns, we show that stochastic internal habit formation models resolve the dichotomy between autocorrelation properties of stochastic discount factor and those of expected returns and provide better explanation of time-variation in expected returns compared to models with either deterministic habit or stochastic external habit. JEL Classification: E21, E44, G12 . We are grateful to Stephen Brown, Martin Lettau, Sydney Ludvigson, Stijn Van Nieuwerburgh, Marti Subrahmanyam, NYU Finance Department seminar participants, and participants of London Business School IV Trans-Atlantic conference for PhD students for valuable comments and suggestions. The usual disclaimer applies.