The equity premium anomaly revised

Diego Corti

July 7, 2010

Contents
0.1 Abel's model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
0.2 Campbell and Cochrane's model . . . . . . . . . . . . . . . . . . 5

1
0.1 Abel's model

Consumption
The preferences are formalized in the following utility function
∞
X
Vt ≡ β s U (ct+s ; vt+s )
s=0

where vt is a preferences parameter, specied by a function of both the consumer

own's consumption of previous period (ct−1 ) and the per capita aggregate con-
sumption of previous period (Ct−1 ):
1−D γ
vt = [cD
t−1 Ct−1 ] γ≥0 D≥0

With dierent assumption on both the two parameters of the preferences

parameter, the intertemporal utility function may assume all three forms pre-
sented in the previous chapters,i.e. the time separable form, the external habit
form and the internal habit form. Therefore :

Time separable
P∞
γ=0 vt = 1 s=0 β s U (ct+s ; 1)

γ > 0, D = 0 External habit

γ P∞
vt = Ct−1 s=0 β s U (ct+s ; Ct+s−1 )

γ > 0, D = 1 Internal habit

P∞
vt = cγt−1 s=0 β s U (ct+s ; ct+s−1 )

With the internal habit parametrization the preferences parameter depends

only on the consumer's own past consumption and, recalling the law of the
habit term (eq.??), that means the persistence or memory term is assumed to
be ν = 1, then Ht = ct−1 .
Abel supposed the following iso-elastic one period utility function:
( vctt )1−α
U (ct ; vt ) = α>0
1−α
where if γ = 0 then the one period utility function has the CRRA form. After-
ward Abel followed the ratio habit model approach. The marginal utility has
the following form:
 −α  1−α
δU ct
1 ct+1 ct+1 1
= − γDβ
δc vt
vt vt+1 vt+1 ct
"  1−α  1−α #  1−α (1)
ct+1 vt ct 1
= 1 − γDβ
vt+1 ct vt ct

Abel considered the output produced by the capital stock in term of con-
sumption good and dened yt as the output per capita of period t. Moreover
he assumed that the output is consumed in the period in which is produced,

2
under the assumption of representative consumer it leads to ct = Ct = yt and
yt = xt , ct = Ct = xt . Equation (1) may be rewrote as:
with yt+1 ct+1 Ct+1

δUt
= Ht vtα−1 c−α
t
δct

where Ht+1 = [1 − γDβx1−α

t+1 x
−γ(1−α)t
] and x−γ
t = vt+1
vt .

Asset Pricing
Suppose that a consumer reduce ct by 1 to purchase a asset which allows the
consumer to increase ct+1 by the gross rate of return (1+rt ). At the equilibrium
the net eect of this air of transaction must be void and the Euler equation
 
Ht+2 γ(α−1) −α
Et β(1 + rt+1 ) x xt+1 = 1
Ht+1 t

must be satised. Abel presented the asset pricing formula of all of three dif-
ferent asset: stock, T-bill and coupon bond, here I am interested on only two
of them:
1. The price of a stock :
qts + yt yt
(1 + rt+1 ) = s =1− s
qt qt
s
qts qt+1
wt = wt+1 = so qts = wt yt s
qt+1 = wt+1 yt+1
yt yt+1
1 + wt+1
(1 + rt+1 ) = xt+1
wt
Ht+2 γ(α−1) −α
wt = βEt [(1 + wt+1 )xt+1 x xt+1 ]
Ht+1 t

2. The price of a T-bill :

f 1
(1 + rt+1 )=
qt
1
f
= βEt [mt,t+1 ]
1 + rt+1
δUt+1
δct+1 Ht+2 γ(α−1) −α
qt = βEt [mt,t+1 ] mt,t+1 = = x xt+1
δUt
δct
Ht+1 t

Abel assumed that that the growth rate of consumption and the growth rate
of dividends are i.i.d. and jointly log-normally distributed to obtain a closed
solution for the rate f risky return (stock) and for the risk-free rate (T-bill).
Under this assumption:
xθt
wt = A
Jt

3
with
θ = γ(α − 1)
1 − βγDE[x(1−α)(1−γ) ]
A = βE[x1−α ]
1 − βE[x(1−α)(1−γ) ]
Jt = Et [Ht+1 ] ≡ 1 − βγDE[x1−α ]xγ

the gross return of stock is expressed by the following formula

xθ
t+1
1 + wt+1 1 + A Jt+1
(1 + rt+1 ) = xt+1 = xθ
xt+1
wt A Jtt

Moreover the risk-free gross return may be obtained starting from the de-
nition of the price of a T-bill:
xθt
qt = Lβ
Jt
so the risk-free gross return is expressed as
f 1 1
(1 + rt+1 )= =
qt Lβf racxθt Jt

with
L = E[x−α ] − βγDE[x1−α ]E[xθ−α ]
The external habit parametrization of γ and D:
γ>0 D=0 (2)
implies
βE[x1−α ]
wt = xθ
1 − βE[x(1−α)(1−γ) ] t
θ = γ(α − 1)
βE[x1−α ]
A=
1 − βE[x(1−α)(1−γ) ]
Jt = Et [Ht+1 ] = Et [Ht+2 ] = 1

so under the assumption of external habit formation the risk-free gross return
is expressed as
f 1 1
(1 + rt+1 )= =
qt E[x ]βxθt
−α

so taking the logarithms the gross return of a risk-free asset (T.bill) become:
1
f
ln(1 + rt+1 ) = − ln β − αµx − α2 σx2 − γ(α − 1) ln xt . (3)
2
Furthermore with Et [Ht+1 ] = Et [Ht+2 ] = 0 the Euler equation becomes:
γ(α−1) −α
βEt [(1 + rt+1 )xt xt+1 ] =1

4
and it may be decomposed using the properties of the covariance
γ(α−1) −α
1 = βEt [(1 + rt+1 )xt xt+1 ]
γ(α−1) −α γ(α−1)
= βEt [(1 + rt+1 )xt xt+1 ]xt
γ(α−1)
= βxt (Et [1 + rt+1 ] + Et [x−α −α
t+1 ] + cov(rt+1 , xt+1 ).

Since it has been assumed the growth rate of consumption and dividends to be
log normally distributed:
1
0 = + ln β + γ(α − 1) ln xt + ln Et [1 + rt ] + αµx + α2 σx2 − ασrt+1 ,x
2

1
ln Et [1 + rt ] = − ln β − γ(α − 1) ln xt − αµx − α2 σx2 + ασrt+1 ,x
2
f
= ln(1 + rt+1 ) + ασrt+1 ,x (4)
Equation (3) says that the risk-less real interest rate equals its value under
CRRA function, less γ(α − 1) ln xt . Holding consumption today and expected
consumption tomorrow constant, an increase in consumption yesterday increases
the marginal utility of consumption today. This makes the representative agent
want to borrow from the future, driving up the real interest rate. Equation (4)
describing the risk premium is exactly the same as the premium obtained with
the CRRA utility function. The external habit adds a term to both gross return
of a risk-free asset and expected gross return of a risky asset.Thi term is known
at time t, and this does not aect the risk premium.

0.2 Campbell and Cochrane's model

First I present the external habit formation, as in Abel (1990) "`catching up wit
the Joneses", describing the external habit model of Campbell and Cochrane
(1999).By "external" I mean that the consumer does not internalize the eect
of his selected level of consumption on the habit formed next period, so an extra
consumption today do not raises habit tomorrow.They assume an additive habit
model rather than the ratio habit model assumed by Abel.Moreover Campbell
and Cochrane consider that the habit level depends on the history of aggregate
consumption.
Identical consumers are assumed to maximize the utility function
∞
(ct − Xt )1−α − 1
(5)
X
E βt
t=0
1−α

where Xt is the level of habit at period t, β > 0 is the time discount factor and
α > 0 is the curvature parameter; moreover they rewrite the utility function in
term of the "`surplus consumption ratio"
(ct − Xt )
St ≡
ct
So the utility function became
∞ ∞
(ct − Xt )1−α − 1 (ct St )1−α − 1
(6)
X X
E βt =E βt
t=0
1−α t=0
1−α

5
Note that with this specication of the utility function the coecient of relative
risk aversion is not more costant, and it has the form of
ct (−α)c−α−1
t St−α−1 α
σt = − −α −α =
ct St St

(Note that here I use σt because here the coecient of relative risk aversion is
not constant)
So a low surplus consumption ratio implies a high relative coecient of risk
aversion.
Following Abel (1990), all consumers are identical so the individual consumption
choice is equals to the average consumption by all individuals in the economy,
therefore the habit level of consumption adjust over the time as aggregate con-
sumption changes.
Moreover,as it's noted by Wachter (2001), Xt can be considered as aggregate
habit because with external habit the consumers does not consider the eect of
the previous individual choice on the habit's level .
Introducing
Ct − Xt
Sta ≡
ct
where Ct is the average consumption , Campbell and Chocrane admit that "each
individual's habit Xt responds to the history of aggregate consumption".
They assume the log surplus consumption ratio sat ≡ lnSta evolves as
sat+1 = (1 − φ)s + φsat + λ(st )(Et ct+1 − ct − g)

where φ and s are parameters, and λ(st ) is the sensitivity function to changes
in consumption.
Moreover they assume the consumption growth as an i.i.d. lognormal process
∆ct+1 = g + vt+1
vt+1 ∼ i.i.d.N (0, σ 2 ) (7)
where ct = lnct = lnCt , g is the mean consumption growth and vt+1 is a
shock that is independent across the time. So the log surplus consumption ratio
evolves positively related to the innovation (or shock) in consumption growth
(Et ct+1 − ct − g ≈ ∆ct+1 − g = vt+1 ).
Campbell and Cochcrane choses the sensitive function, λ(st ), to satisfy three
conditions:
1. The risk-free rate is constant
2. Habit is predetermined at the steady state
3. Habit move nonnegatively with consumption everywhere
their specication is

1 − 2(st − s) − 1, if st ≤ smax
( p
1
λ(st ) = S (8)
0, if st ≥ smax

6
with1 , r
α
S=ς (9)
1−φ
where S is the surplus consumption ratio at the steady state and smax is a
constant determined by λ(smax ) = 0.Wachter (2001) arm that the second
case never happens in the continuous-time case and it happens rarely in the
discrete-time case so it does not aect the behavior of the model. The sensitive
function given by Campbell and Cochrane is a function of −st , so λ increases
to innity as St decline to zero. Since the utility function has the form (6), the
Intertemporal marginal rate of substitution is specied as
ct+1 −Xt+1
St+1 ct+1 −α ct+1 ct+1 −α ct+1 − Xt+1 −α
Mt+1 = β( ) = β( ct −Xt
) = β( )
St ct ct
ct ct − Xt

With Mt+1 it is possible to dene the real risk-free rate as

1 1
1 + rtf = =β ct −Xt
Et (Mt+1 ) (c )α
t+1 −Xt+1

Note that
1 = Et [Mt+1 (1 + rtf ]
St+1 ct+1 −α (10)
= Et [β( ) (1 + rtf )]
St ct
is the Eulero equation for the real risk-free rate.
Cambell and Cochrane specify the real risk-free rate as
α2 ς 2
ln(1 + rtf ) = − ln(β) + αg − α(1 − φ)(st − s) − [1 + λ(st )]2 (11)
2
where the term (st − s) reect that if the surplus consumption ratio is low or it
falls respect to the steady state value the marginal utility of current consumption
is high, the intertemporal marginal rate of substitution is low and then the
consumer would to borrow from the future; the last term is dened by Cambell
and Chocrane as a precautionary saving term. Substituting the (9) in the (8)
and then the (8) in the (11), it is able to see tha the real risk-free rate is constant
α
ln(1 + rtf ) = − ln(β) + αg − [1 − φ]
2
Cambell and Cochrane dening the stock market as a claim to the future con-
sumption stream, so they introduce the price-consumption ratio instead the
price-dividend ratio for their analysis of the real rate to stock (risky asset). So
the Eulero equation become
1 = Et [Mt+1 (1 + rt )]
with
pt+1 − dt+1
1 + rt =
pt

1 ς is the standard deviation of the Intertemporal marginal rate of susbtitution specied by

Campbell and Cochcrane(1999)