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RFS Advance Access published online on August 22, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn074
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Habit Formation, Incomplete Markets, and the Significance of Regional Risk for Expected Returns

George M. Korniotis
Federal Reserve Board, Division of Research and Statistics

Send correspondence to George M. Korniotis, Board of Governors of the Federal Reserve System, Division of Research and Statistics, Risk Analysis Section (Mail Stop 91), 20th Street and Constitution Avenue NW, Washington, DC 20551, telephone: (202) 452-2581, or e-mail: George.M.Korniotis{at}frb.gov.

JEL Classification: E21, G12


  Abstract

This paper introduces a consumption-based capital asset pricing model (CCAPM) that combines undiversifiable income shocks and external habit formation. Using US state-level data, the paper provides realistic estimates for preference parameters when the external habit of the state investors is based on the consumption of the four Census regions. The model also implies four asset pricing factors: the cross-sectional means of consumption growth and habit growth (capturing national systematic risk) and the cross-sectional variances of consumption growth and habit growth (capturing regional systematic risk). This four-factor model has greater power in explaining expected returns than the CCAPM described in Breeden (1979).

I would like to thank Sean Campbell, George Constantinides, Tom Cosimano, Michael Gibson, Alok Kumar, Martin Lettau, Tim Loughran, Sydney Ludvigson, Alex Michaelides, Matthew Pritsker, Paul Schultz, Jessica Wachter, and seminar participants at the University of Notre Dame and the Board of Governors of the Federal Reserve System for their comments and helpful suggestions. I would also like to thank Tobias Moskowitz, the editor, and two anonymous referees for their valuable feedback. The analysis and conclusions herein are mine and should not be taken to indicate any endorsement by the Board of Governors or its staff.


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