Mean reversion in asset returns and time non-separable preferences

Abstract

Time non-separable preferences are used in combination with various specifications of the endowment process to calibrate the Capital Asset Pricing Model (CAPM). Time non-separability is caused either by habit persistence or durability. It is demonstrated that the model can indeed produce the amount of mean reversion detected in historical returns. Specifically, habit persistence is required to match negative autocorrelation of annual asset returns and durability is needed to replicate positive autocorrelation detected in monthly asset returns. In addition, the CAPM with habit persistence can predict negative expected returns when calibrated to monthly data.