Working Paper

Asset Return Dynamics under Habits and Bad-Environment Good-Environment Fundamentals

Abstract: We introduce a \"bad environment-good environment\" (BEGE) technology for consumption growth in a consumption-based asset pricing model with external habit formation. The model generates realistic non-Gaussian features of consumption growth and fits standard salient features of asset prices including the means and volatilities of equity returns and a low risk free rate. BEGE dynamics additionally allow the model to generate realistic properties of equity index options prices, and their comovements with the macroeconomic outlook. In particular, when option implied volatility is high, as measured for instance by the VIX index, the distribution of consumption growth is more negatively skewed.

Keywords: VIX; equity premium; habit; risk aversion; skewness;

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Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2015-07-03

Number: 2015-53

Pages: 62 pages