Loss aversion, habit formation and the term structures of equity and interest rates

I propose a consumption-based asset pricing model that jointly explains the high equity premium, the counter-cyclical behaviour of stock returns, the upward-sloping term structure of interest rates and the downward-sloping term structure of equity. The driving forces behind these results are loss av...

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Bibliographic Details
Published in:Journal of economic dynamics & control 2015-04, Vol.53, p.103-122
Main Author: Curatola, Giuliano
Format: Article
Language:English
Subjects:
Assets
Consumption
Dividend strips
Economic models
Economic theory
Equity
General equilibrium
Habit formation
Interest rates
Loss control
Loss-aversion
Price models
Rates of return
Risk premiums
Stock returns
Studies
Yield curve
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Summary:I propose a consumption-based asset pricing model that jointly explains the high equity premium, the counter-cyclical behaviour of stock returns, the upward-sloping term structure of interest rates and the downward-sloping term structure of equity. The driving forces behind these results are loss aversion and time-varying habits. The high premium is the reward for holding assets that deliver low returns when consumption descends below habits. The term structure of interests rates is upward-sloping because long-term bonds are more sensitive to fluctuations of discount rates. The term structure of equity is downward-sloping because long-horizon equity gives higher chances to beat consumption habits than short-horizon equity.
ISSN:0165-1889
1879-1743
DOI:10.1016/j.jedc.2015.02.009