Loss aversion, habit formation and the term structures of equity and interest rates

Abstract

I propose a consumption-based asset pricing model that jointly explains the high equity premium, the counter-cyclical behaviour of stock returns, the upward-sloping term structure of interest rates and the downward-sloping term structure of equity. The driving forces behind these results are loss aversion and time-varying habits. The high premium is the reward for holding assets that deliver low returns when consumption descends below habits. The term structure of interests rates is upward-sloping because long-term bonds are more sensitive to fluctuations of discount rates. The term structure of equity is downward-sloping because long-horizon equity gives higher chances to beat consumption habits than short-horizon equity.