Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Behavior

59 Pages Posted: 31 May 2004 Last revised: 14 Sep 2022

See all articles by Xiaohong Chen

Xiaohong Chen

Yale University - Cowles Foundation

Sydney C. Ludvigson

New York University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: May 2004

Abstract

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.

Suggested Citation

Chen, Xiaohong and Ludvigson, Sydney C., Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Behavior (May 2004). NBER Working Paper No. w10503, Available at SSRN: https://ssrn.com/abstract=552108

Xiaohong Chen

Yale University - Cowles Foundation ( email )

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Sydney C. Ludvigson (Contact Author)

New York University - Department of Economics ( email )

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