Finance and Economics Discussion Series

Habit formation heterogeneity: Implications for aggregate asset pricing

Eduard Dubin, Olesya V. Grishchenko, and Vasily Kartashov
2012-07

Abstract: We study the asset pricing implications of a general equilibrium Lucas endowment economy inhabited by two agents with habit formation preferences. Preferences are modeled either as internal or external habits. We allow for agents' heterogeneity in relative risk aversion and habit strength. We explicitly compute aggregate prices, such as equity premium, equity volatility, Sharpe ratio, interest rate volatility, and asset holdings for both types of preferences. Equilibrium quantities are computed using a recently developed algorithm of Dumas and Lyasoff (2011), which is refined to capture time nonseparability induced by habit. We obtain that internal habits provide for a considerable improvement in obtaining aggregate asset pricing quantities consistent with historically observed magnitudes as opposed to ``catching up with Joneses" preferences.

Keywords: Consumption-based asset pricing models, external habit, internal habit, heterogeneity, time nonseparability, general equilibrium, recursive solution