Don’t break the habit: structural stability tests of consumption asset pricing models in the UK

Abstract

This paper investigates the structural stability of four alternative consumption based asset pricing models, the traditional power utility consumption based capital asset pricing model (C-CAPM), the recursive preferences model proposed by Epstein and Zin (1989, 1991), and two habit formation specifications, the form proposed by Abel (1990) and the model of Campbell and Cochrane (1999), using the tests of Hall and Sen (1999). The ability of the models to price stocks and stocks and a short-term interest rate (i.e., the equity premium) is assessed. Evidence is found supportive of both the habit formation specifications and the traditional C-CAPM. The preferred specification based on parameter estimates and structural stability is that of Campbell and Cochrane.

Acknowledgements

We would like to thank Alastair Hall and Amit Sen for comments and providing code and participants at the MMF Annual Conference 2003, Cambridge for their comments and suggestions.

Notes

Within the model R_m , _t is assumed to be the return on the market portfolio which includes human capital, in practice this is not the case so the model suffers from Roll's (1977) critique. However, in line with Epstein and Zin (1991), we assume that the mismeasurement of market portfolio will not have a discernable impact upon the empirical results.