Consumption-Based Asset Pricing with Prospect Theory and Habit Formation

In this chapter, we propose a novel model to incorporate prospect theory into the consumption-based asset pricing model, where habit formation of consumption is employed to determine endogenously the reference point. Our model is motivated by the common element of prospect theory and habit formation of consumption that investors care little about the absolute level of wealth (consumption), but rather pay attention to gains or losses (excess or shortage in consumption level) compared to a reference point. The results show that if investors evaluate their excess or shortage amounts in consumption relative to their habit consumption levels based on prospect theory, the equity premium puzzle can be resolved.