HABIT PERSISTENCE AND THE NOMINAL TERM PREMIUM PUZZLE: A PARTIAL RESOLUTION

Abstract

I. INTRODUCTION The consumption-based capital asset pricing model (CCAPM) has become the dominant paradigm in asset pricing theory because of its intuitive characterization of asset risk. That is, unlike expectations-based asset pricing theories (e.g. the present value model of stock prices) which inherently assume risk neutrality, the CCAPM is predicated upon risk-averse agents attempting to achieve a smooth consumption profile through the trading of assets. From this perspective, the risk of an asset is captured by the covariance of the asset's return with agents' marginal utility of consumption, or, more broadly, agents' intertemporal marginal rate of substitution of wealth. With this characterization, the CCAPM extends the results of the standard CAPM, i.e. the risk of an asset is reflected in the covariance of the asset's return with the market portfolio, to a general equilibrium setting. However, this intuitively appealing theory has not found much empirical support. Perhaps the most famous demonstration of inconsistency between the theory and data was Rajnish Mehra and Edward Prescott's [1985] analysis of the equity premium, i.e. the difference between the average return on equity and that on government bonds. Using calibration methods rather than a formal statistical approach, they showed that a standard CCAPM severely underpredicts the size of the risk premium on equity. The important implication of this finding is that the basic CCAPM incorrectly models the covariance structure between the return on equity and asset holders' intertemporal marginal rate of substitution. Economists' response to this empirical rejection has been to either identify new sources of risk (e.g., that implied by a particular monetary environment as in Labadie [1989]) or define alternative preferences toward risk (e.g., the use of non-expected utility theory as presented in Weil [1989] and Epstein and Zin [1989]). The potential for this research was illustrated recently by George Constantinides's [1990] resolution of the equity premium puzzle in a model that included habit formation in consumption. By relaxing the standard CCAPM's assumption of time-separable preferences, Constantinides demonstrated that a relatively smooth consumption profile and large risk premium on equity are consistent with equilibrium in a complete markets, rational-expectations framework.(1) I use this insight to study another risk premium puzzle; specifically the behavior of the nominal term premium. The existence of a nominal term premium puzzle was demonstrated in papers by Backus, Gregory, and Zin [1989] and Salyer [1990] in which the term structure implications within a Lucas [1982] type cash-in-advance (CIA) economy were studied. While some equilibrium characteristics of this model were consistent with the data, both papers demonstrated that the model predicts the wrong sign of the term premium: the theory implies the term premium should be negative while, based on quarterly data for yields of three- and six-month U.S. Treasury Bills over the period 1959.1-1989.4, the observed term premium is positive. Similar to the equity premium puzzle as posed by Mehra and Prescott [1985], the prediction of a negative average term premium signals a critical discrepancy between the risk associated with nominal bonds as perceived by market participants and as captured by the models. Moreover, this term premium puzzle is in some sense a stronger rejection of the underlying asset pricing model than that embodied by the equity premium puzzle. To see this, recall that within the consumption-based asset pricing model, the sign of the risk premium on any asset depends on the sign of the covariance between the marginal utility of consumption and that asset's return. Applying this reasoning to the case of the equity premium suggests that, while the discrepancy in size between the observed equity premium and that generated within the model is troubling, the model's prediction of a positive equity premium implies that the basic payout structure of equity within the model is consistent with that in the data (e. …