A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-sectional Heterogeneity?

Abstract

In this paper we study the asset pricing implications of a parsimonious twoagent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution. The parameter values for the model are taken from the business cycle literature and are not calibrated to match any financial statistic. Yet, with a risk aversion of two, the model is able to explain a large number of asset pricing phenomena including all the facts matched by the external habit model of Campbell and Cochrane (1999). Examples in this list include a high equity premium and a low risk-free rate; a counter-cyclical risk premium, volatility and Sharpe ratio; predictable stock returns with coefficients and R 2 values of long-horizon regressions matching their empirical counterparts, among others. In addition the model generates a risk-free rate with low volatility (5.7 percent annually) and with high persistence. We also show that the similarity of our results to those from an external habit model is not a coincidence: the model has a reduced form representation which is remarkably similar to Campbell and Cochrane's framework for asset pricing. However, the macroeconomic implications of the two models are quite different, favoring the limited participation model. Moreover, we show that policy analysis yields dramatically different conclusions in each framework.

Direct Preference for Wealth in Aggregate Household Portfolios

“…Our results indicate that relative risk aversion with respect to consumption (wealth) was counter-(pro-) cyclical, with the overall indirect utility risk aversion being counter-cyclical (finding 4). This result would be consistent with the predictability puzzle whereby the conditional premia are observed to fall during booms, and pick up during recessions (Cochrane, 1997;Guvenen, 2003a). In the absence of strong conditional heteroscedasticity effects in the quantities of consumption or market risks, predictability would be explained in our model by cyclical movements in risk aversion.…”

“…For example, it is well known that participation in risky asset markets is mainly limited to a relatively small share of individuals (Mankiw and Zeldes, 1991;Haliassos and Bertaut, 1995;Guvenen, 2003b) who appear to have different preferences compared to the average agent. Empirical evidence is consistent with stockholders (i) being wealthier (Poterba, 2000;Aït-Sahalia et al, 2004;Reynard, 2004), and having (ii) a larger elasticity of inter-temporal substitution (Vissing-Jørgensen, 2002;Guvenen, again with the XRI index. 5 The data suggests that (i) wealth is strongly pro-cyclical whereas (ii) consumption has comparatively negligible cyclical component, such that (iii) the consumption share of wealth is strongly counter-cyclical.…”

When is market incompleteness irrelevant for the price of aggregate risk (and when is it not)?

“…This is the approach adopted in the literature on limited participation (see e.g. Guvenen (2003), Vissing-Jorgensen (2002), Gomez and Michaelides (2007) and Attanasio, Banks, and Tanner (2002)). The second approach consists of concentrating labor income risk in recessions.…”

Reconciling the Return Predictability Evidence

“…McGrattan and Prescott (2005) argued that persistent changes in the tax code can explain the persistent decline in the equity premium. Lastly, models of limited stock market participation argue that the gradual entry of new participants has persistently depressed equity premia (Vissing-Jorgensen (2002), Calvet, Gonzalez-Eiras, and Sadini (2003), and Guvenen (2003)). Other models argue that there was a persistent increase in the long-run growth rate of the economy in the 1990s (Quadrini and Jermann (2003) and Jovanovic and Rousseau (2003)).…”