Habit formation and recursive intertemporal preference in asset pricing

: empirical investigation and performance analysis

Abstract

Despite its sound economic foundation, the Consumption-based Capital Asset Pricing Model (CCAPM) has not been regarded as a standard framework of studying the cross section of expected asset returns due to its poor performance and economic puzzles. We investigate the effect of exotic preferences on the canonical CCAPM in terms of improvements in empirical cross sectional performance and reduction of economically implausible results. Among the class of exotic preferences, habit formation and Esptein-Zin-Weil recursive utility have been well received by economists and financial researchers in modeling intertemporal equilibrium of prices. However, the cross sectional performances of these exotic preferences have not received much attention in the literature. An empirical revisit to the canonical CCAPM motivates our exploration of the cross sectional performance of CCAPM with recursive utility and habit formation respectively. For the latter, we look at ‘catching up with the Joneses’ type of external habit formation with ratio [Abel (1990)] and difference [Campbell and Cochrane (1999)] specifications of effective consumption. Based upon economic foundations, recursive utility and habit formation with ratio specification both incorporate additional pricing factors into canonical CCAPM. Habit formation with difference specification replaces consumption growth with a consumption variant. Our test assets include the US risk free rate and returns on 10 groups of stocks, sorted according to firm size, partitioned from the aggregate US equity market. Our data set exhibits the well-known size effect discovered by Banz (1981). A model fitting the cross section in our test assets means that it also prices size effect well. We find that recursive utility has strong cross sectional performance, including the risk free rate, but investors have no preference for future consumption at all. Habit formations’ cross sectional improvements are slight but investors have reasonable time preference. Interestingly, the major empirical improvements of two classes of exotic preferences are non-overlapping. We then look at the novel blend of the two classes, which has cross sectional performance close to recursive utility and suggest investors have reasonable time preference. However, none of the models resembles a definite solution to the equity premium puzzle. JEL Classifications: G12; C21 Keywords: Asset pricing; recursive utility; habit formation; cross section of expected asset returns

Date of Award	4 Oct 2004
Original language	English
Awarding Institution	City University of Hong Kong
Supervisor	Yum Keung Fred KWAN (Supervisor)