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The Equity Premium: It’s Still a Puzzle
In this paper, we develop a consumption-based asset pricing model motivated by prospect theory, where habit formation determines the endogenous reference point. This exploits the similarity between habit formation and prospect theory. Both emphasize that the investor does not care about the absolute amount of gain or loss, but rather compares the gain or the loss experienced to a benchmark. The results show that when taking people's loss averse attitude over consumption into consideration, our model is capable of resolving the equity premium puzzle.
Review of Pacific Basin Financial Markets and Policies – World Scientific Publishing Company
Published: Mar 1, 2005
Keywords: Prospect theory habit formation loss aversion consumption-based asset pricing model
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