From Equity Premium Puzzle to Expectations Puzzle: A General Equilibrium Production Economy with Stochastic Habit Formation
May 22, 2000
Qiang Dai
ABSTRACT
This paper develops a general equilibrium model for a representative agent, production economy with stochastic
internal habit formation. The model
describes a scale-independent economy, with a unique stochastic investment opportunity set. Local correlation between
the stochastic interest rate and
time-varying market price of risk can be determined endogenously and leads to correct predictions on the sign and
magnitude of several major empirical
puzzles in both equity and bond markets.
In the empirical part of the paper, we calibrate our model, simultaneously, to the equity premium puzzle, the riskfree
rate puzzle, and the expectations
puzzle, and show that the three puzzles are completely resolved under reasonable parameter values.
Thus, we establish, conclusively, the inextricable link between the equity and bond markets, both theoretically
and empirically.
Our model subsumes the internal habit formation models of Sundaresan (1989) and Constantinides (1990), and, perhaps
somewhat surprisingly, the
external habit formation model of Campbell and Cochrane (1999).
Qiang Dai
Institution: Stern School of Business, New York University
Email: qdai@stern.nyu.edu
Telephone: 212-998-0358
Home Page: http://www.stern.nyu.edu/~qdai
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