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A parsimonious macroeconomic model for asset pricing: Habit formation or cross-sectional heterogeneity? (2005)
| Citations: | 152 - 2 self |
BibTeX
@TECHREPORT{Guvenen05aparsimonious,
author = {Fatih Guvenen},
title = {A parsimonious macroeconomic model for asset pricing: Habit formation or cross-sectional heterogeneity? },
institution = {},
year = {2005}
}
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Abstract
In this paper we study the asset pricing implications of a parsimonious two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution. The parameter values for the model are taken from the real business cycle literature and are not calibrated to match any financial statistic. Yet, with a risk aversion of two, the model is able to explain a large number of asset pricing phenomena including all the facts matched by the external habit model of Campbell and Cochrane (1999). Examples in this list include a high equity premium and a low risk-free rate; a counter-cyclical risk premium, volatility and Sharpe ratio; predictable stock returns with coefficients and R2 values of long-horizon regressions matching their empirical counterparts, among others. In addition the model generates a risk-free rate with low volatility (5.7 percent annually) and with high persistence. We also show that the similarity of our results to those from an external habit model is not a coincidence: the model has a reduced form representation which is extremely similar to Campbell and Cochrane’s framework for asset pricing. However,themacroeconomic implications ofthetwomodelsareverydifferent, favoring the limited participation model. Moreover, we show that policy analysis yields dramatically different conclusions in each framework.
Keyphrases
asset pricing parsimonious macroeconomic model habit formation cross-sectional heterogeneity external habit model low volatility empirical counterpart high persistence large number key feature asset pricing implication counter-cyclical risk premium predictable stock return different conclusion parsimonious two-agent macroeconomic model limited participation model sharpe ratio form representation asset pricing phenomenon policy analysis yield r2 value risk-free rate intertemporal substitution low risk-free rate limited participation high equity premium risk aversion stock market financial statistic themacroeconomic implication ofthetwomodelsareverydifferent parameter value real business cycle literature long-horizon regression
