International Asset Pricing under Habit Formation and Idiosyncratic Consumption Risk

This paper presents a consumption-based asset pricing model to explain the equity premium and riskfree puzzles as well as the predictability of returns in the international equity markets. We find that because the model entails idiosyncratic consumption risk which is higher than the aggregate consumption risk, the model helps lower the investor risk aversion needed to explain the mean equity premiums. In addition, because the model also allows for habit formation that disentangles intertemporal substitution from investor risk aversion, the model can resolve the riskfree rate puzzle. Further, as the timevarying individual investor risk aversion and the re-distribution of wealth among heterogeneous investors are contributing factors to the time-varying equity premiums, the model explains larger portions of the long-horizon predictability for many countries’ equity markets and the world market portfolio than the world representative-agent model. In contrast, the power utility model with or without idiosyncratic consumption risk fails to explain the level of the real riskfree rate or the predictability of returns.