Asset Prices Under Non-Additive Habits

We explore the asset pricing implications of a RBC model with capital adjustment costs and multiplicative habits in the utility function. The model is consistent with a set of financial regularities that can not be accounted for by standard consumption-based models. It generates the observed equity premium and the market price of risk. It also reproduces the leading countercyclical and lagging procyclical behavior of the riskfree rate, and a positive correlation between consumption and stock returns that is well below unity. Interestingly, findings on the financial side do not conflict with good business cycle predictions. Models with habit formation tend to overpredict the riskfree rate volatility. We find that this shortcoming is slightly mitigated by our model economy.