Abstract
This paper extends Longstaff and Piazzesi (2004, Journal of Financial Economics, 74, 401–421.) to a habit formation model. By combining corporate fraction ratio, and surplus consumption ratio, we derive closed-form solutions for stock values when dividends, habit ratio and consumption follow exponential affine jump-diffusion processes. We can prove that Longstaff and Piazzesi (2004) is only a special case of our model. In addition, calibrated results show that the corporate fraction and habit ratio to shocks significantly increases the equity premium and decreases the risk-free rate. The model determines realistic values for the equity premium and the risk-free rate.
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