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Transactions Costs and the Equity Premium Puzzle

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Abstract

Campbell and Cochrane's (1999b) habit formation model is able to resolve the equity premium and riskless interest rate puzzles, but only for high values of relative risk aversion. In this paper, I incorporate transactions costs in the Campbell and Cochrane model and find that the required level of relative risk aversion at the steady state reduces from 35 to 15. Thus, transactions costs seem able to reduce, but not completely solve, the remaining puzzle.

Suggested Citation

  • Sanghyun Hong, 2020. "Transactions Costs and the Equity Premium Puzzle," Working Papers in Economics 20/16, University of Canterbury, Department of Economics and Finance.
    • Handle: RePEc:cbt:econwp:20/16
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    File URL: https://repec.canterbury.ac.nz/cbt/econwp/2016.pdf
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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Ellen R. McGrattan & Edward C. Prescott, 2003. "Average Debt and Equity Returns: Puzzling?," American Economic Review, American Economic Association, vol. 93(2), pages 392-397, May.
    3. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    4. Ellen R. McGrattan & Edward C. Prescott, 2001. "Taxes, Regulations, and Asset Prices," NBER Working Papers 8623, National Bureau of Economic Research, Inc.
    5. John H. Cochrane, 2016. "The Habit Habit," Economics Working Papers 16105, Hoover Institution, Stanford University.
    6. Wachter, Jessica A., 2005. "Solving models with external habit," Finance Research Letters, Elsevier, vol. 2(4), pages 210-226, December.
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    More about this item

    Keywords

    Transaction Costs; Equity Premium Puzzle;

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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