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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27412
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| Title: | From Equity Premium Puzzle to Expectations Puzzle: General Equilibrium
Production Economy with Stochastic Habit Formation |
| Authors: | Dai, Qiang |
| Issue Date: | 22-May-2000 |
| Series/Report no.: | S-AM-00-02 |
| 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 risk-free 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). |
| URI: | http://hdl.handle.net/2451/27412 |
| Appears in Collections: | Asset Management
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