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External Habit and the Cyclicality of Expected Stock Returns

Thomas D. Tallarini, Jr. and Harold H. Zhang
The Journal of Business
Vol. 78, No. 3 (May 2005), pp. 1023-1048
DOI: 10.1086/429652
Stable URL:
Page Count: 26
Subjects: Finance Business
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We estimate an equilibrium asset pricing model in which agents' preferences have an unobserved external habit using the efficient method of moments (EMM). Given the estimated structural parameters, we examine the cyclical behavior of expected stock returns in the model. We find that the estimated structural parameters imply countercyclical expected stock returns as documented in existing empirical studies. The model, however, is still rejected at the 1% level. Detailed examination of the moment conditions in our estimation indicates that the model performs reasonably well in matching the mean of returns, but it fails to capture the higher‐order moments.

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