Life with habit and expectation: A new explanation of equity premium puzzle

Previous writers have attempted to resolve the equity premium puzzle by employing a utility function that depends on current consumption minus (or relative to) past habit consumption. This paper points out that an individual's current utility may also depend upon how well off in the recent past...

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Bibliographic Details
Published in:Economic notes - Monte Paschi Siena 2021-02, Vol.50 (1), p.n/a
Main Authors: Cover, James P., Zhuang, Boyi
Format: Article
Language:English
Subjects:
Consumption
Discounting
Equity
equity premium puzzle
expectation
habit
Risk
Risk factors
Utility functions
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Summary:Previous writers have attempted to resolve the equity premium puzzle by employing a utility function that depends on current consumption minus (or relative to) past habit consumption. This paper points out that an individual's current utility may also depend upon how well off in the recent past he or she had expected to be today. Hence we add the concept “expectation formation” to the utility modification term in a model with a habit‐formation utility function. We apply the model to the equity premium puzzle and find that it is able to fit the data with a relatively low coefficient of relative risk aversion. Furthermore, we introduce an updated data sample and apply different values of discounting factors, and find that in all circumstances, the model is able to generate coefficients of risk aversion that are consistent with theory. Hence we conclude that the model is able to resolve the equity premium puzzle.
ISSN:0391-5026
1468-0300
DOI:10.1111/ecno.12174