Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Behavior
This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. We treat the functional form of the habit as unknown, and to estimate it along with the rest of the model's finite dimensional parameters. Using quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, the habit formation is better described as internal rather than external, and the estimated time-preference parameter and the power utility parameter are sensible. In addition, the estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross-sectional stock return data . We find that an internal habit SDF proxy can explain a cross-section of size and book-market sorted portfolio equity returns better than (i) the Fama and French (1993) three-factor model, (ii) Lettau and Ludvigson (2001) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM.
We acknowledge financial support from the National Science Foundation (Chen), the Alfred P. Sloan Foundation (Ludvigson), and the C.V. Starr Center at NYU. We thank Kenneth French for providing the portfolio return data, and are grateful to John Campbell, David Chapman, John Cochrane, Yuichi Kitamura, Per Krusell, Lars Hansen, Oliver Linton, Anthony Lynch, Monika Piazzesi, Masao Ogaki, B. Ravikumar, Martin Schneider, Jim Stock, George Tauchen, Zhenyu Wang and seminar participants at Carnegie Mellon GSIA, Columbia University, Norwegian School of Economics and Business Administration, Norwegian School of Management, Notre Dame, NYU, University of Chicago, University of Maryland, University of Pennsylvania, 2004 CIREQ-CIRANO Financial Econometrics Conference at Montreal, 2004 NBER Spring Asset Pricing meeting, 2003 NBER Summer Institute, 2004 American Finance Association Meetings, and 2004 Econometric Society winter meetings for useful comments. Jinyong Kim and Artem Voronov provided excellent research assistance. Any errors or omissions are the responsibility of the authors. The views expressed herein are those of the author(s) and not necessarily those of the National Bureau of Economic Research.
Xiaohong Chen & Sydney C. Ludvigson, 2009. "Land of addicts? an empirical investigation of habit-based asset pricing models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 24(7), pages 1057-1093.