This paper aims to explain the countercyclical behavior of the equity risk premium and the stock return volatility by introducing an external habit formation feature in the standard representative-agent consumption-based asset pricing model, in form of the so called “catching up with the Joneses” preferences. These preferences imply that the relative risk aversion of the agents in the economy is constant over time and varies across the agents, which generates an endogenous wealth process, that in turn creates a countercyclical behavior in the risk premium and the conditional stock return volatility. As the agents with lower risk aversion distribute a greater fraction of their wealth to risky assets, their wealth decreases relatively more in reaction to cyclical downturns, shifting the aggregate wealth towards more risk averse individuals. These more risk averse agents, however, demand a higher compensation for risk, leading to an increase of the aggregate equity risk premium in response to a fall in stock prices.
One of the most studied topics in modern economics are the market mechanisms that lead to the determination of asset prices in an economy. The empirical research indicates that there is a link between the historically observed asset prices and macroeconomic developments. One of the most important observations are the countercyclical behavior of the equity risk premium and the stock return volatility, implying that the excess return of common stocks over the risk-free rate during business cycle troughs is significantly higher than during expansions.
Table of Contents
1. Introduction
2. “Catching up with the Joneses” Preferences
3. Conceptual Framework
3.1 The Model
3.2 The Competitive Equilibrium
4. The Results
4.1 Theoretical Implications
4.2 Simulated Outcome
5. Discussion
6. Conclusion
Research Objectives and Key Topics
The primary objective of this paper is to investigate how the introduction of "catching up with the Joneses" preferences into a representative-agent consumption-based asset pricing model can explain observed countercyclical behaviors in equity risk premia and stock return volatility, thereby addressing the equity premium and risk-free rate puzzles.
- Mechanisms of "catching up with the Joneses" preferences.
- Endogenous wealth redistribution processes and their impact on asset prices.
- Modeling of competitive equilibrium in a consumption-based asset pricing framework.
- Calibration and comparison of simulated model outcomes versus historical data.
- The role of preference heterogeneity in generating empirically plausible return patterns.
Excerpt from the Paper
1. Introduction
One of the most studied topics in modern economics are the market mechanisms that lead to the determination of asset prices in an economy. The empirical research indicates that there is a link between the historically observed asset prices and macroeconomic developments. One of the most important observations are the countercyclical behavior of the equity risk premium and the stock return volatility, implying that the excess return of common stocks over the risk-free rate during business cycle troughs is significantly higher than during expansions (Fama & French, 1989; Cochrane, 1991). This paper aims to explain this countercyclical behavior by introducing an external habit formation feature in the standard representative-agent consumption-based asset pricing model, in form of the so called “catching up with the Joneses” preferences (Abel, 1990; Galí, 1994; Chan & Kogan, 2002).
These preferences imply that the relative risk aversion of the agents in the economy is constant over time and varies across the agents, which generates an endogenous wealth process, that in turn creates a countercyclical behavior in the risk premium and the conditional stock return volatility (Chan & Kogan, 2002). As the agents with lower risk aversion distribute a greater fraction of their wealth to risky assets, their wealth decreases relatively more in reaction to cyclical downturns, shifting the aggregate wealth towards more risk averse individuals. These more risk averse agents, however, demand a higher compensation for risk, leading to an increase of the aggregate equity risk premium in response to a fall in stock prices (ibid.).
Summary of Chapters
1. Introduction: This chapter defines the research problem, specifically the countercyclical behavior of risk premia and volatility, and introduces the "catching up with the Joneses" preference framework.
2. “Catching up with the Joneses” Preferences: This section details the theoretical foundation of consumption externalities and how these preferences influence portfolio choice and asset pricing.
3. Conceptual Framework: This chapter develops the formal model, including the utility function, the endowment process, and the competitive equilibrium within an Arrow-Debreu economy.
4. The Results: This chapter presents the theoretical implications of the model and provides a calibration analysis using historical financial data to assess model performance.
5. Discussion: This section evaluates the model's effectiveness in resolving existing economic puzzles while acknowledging its specific limitations regarding calibration and sensitivity.
6. Conclusion: The final chapter summarizes the findings, confirming that investor heterogeneity is critical for understanding asset price dynamics and suggests directions for future research.
Keywords
Asset Pricing, Habit Formation, Catching up with the Joneses, Equity Premium Puzzle, Risk-Free Rate Puzzle, Consumption Externalities, Preference Heterogeneity, Countercyclical Behavior, Wealth Distribution, Portfolio Choice, Stochastic Discount Factor, Market Risk, Sharpe Ratio, Risk Aversion, Economic Models.
Frequently Asked Questions
What is the core focus of this research paper?
The paper examines how "catching up with the Joneses" preferences in an asset pricing model can help explain historical patterns of stock market behavior, such as countercyclical volatility and risk premia.
What are the primary themes discussed?
Key themes include consumption externalities, the impact of varying risk preferences on wealth redistribution, and the mathematical modeling of equilibrium in financial markets.
What is the central research question or goal?
The goal is to provide a theoretical model that explains the "equity premium puzzle" and "risk-free rate puzzle" by incorporating agent heterogeneity through external habit formation.
Which scientific methodology is employed?
The paper utilizes a consumption-based representative agent model with external habit formation, analyzed through a social planner's problem and implemented as a sequential-trade economy.
What is covered in the main body of the work?
The main body covers the development of utility functions involving consumption externalities, the derivation of equilibrium conditions, and the quantitative simulation of financial data compared to historical benchmarks.
Which keywords best characterize this work?
Essential keywords include Asset Pricing, Habit Formation, Equity Premium Puzzle, Preference Heterogeneity, and Countercyclical Behavior.
How does the model address the "equity premium puzzle"?
The model shows that by introducing heterogeneous risk preferences, the economy experiences endogenous wealth redistribution during market downturns, leading to higher risk compensation and thus reconciling the model with historically observed high risk premia.
What role does the "standard of living" play in the author's utility model?
The standard of living, defined as a moving average of aggregate consumption, acts as an external benchmark for individual agents. High risk-averse agents attempt to track this benchmark, which influences their consumption and investment decisions.
Why did the author use a century-long dataset (1889-1994) for calibration?
The author argues that using a longer timeframe ensures that significant historical events, such as the Great Depression, are included, and it helps to avoid the inaccuracies inherent in matching moments solely from postwar data.
What are the acknowledged limitations of the proposed model?
The model struggles to perfectly match unconditional data moments when calibrated over shorter periods and is highly sensitive to the time variation of interest rates, suggesting that additional factors beyond preference heterogeneity may influence market dynamics.
- Arbeit zitieren
- Julian Veil (Autor:in), 2021, External Habit Formation and Asset Prices, München, GRIN Verlag, https://www.hausarbeiten.de/document/1005687
