Journal
JOURNAL OF FINANCIAL ECONOMICS
Volume 79, Issue 2, Pages 365-399Publisher
ELSEVIER SCIENCE SA
DOI: 10.1016/j.jfineco.2005.02.004
Keywords
habit formation; expectations puzzle; term structure; affine models; risk premium
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This paper proposes a consumption-based model that accounts for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated to data on consumption, inflation, and the aggregate market, the model produces realistic means and volatilities of bond yields and accounts for the expectations puzzle. The model also captures the high equity premium and excess stock market volatility. (c) 2005 Elsevier B.V. All rights reserved.
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