Narrow Results

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.

The primary and secondary effects of various spatial and transportation policies can be evaluated with models of activity–travel behavior. Whereas existing activity-based models of travel demand simulate a typical day, dynamic models simulate behavioral response to endogenous or exogenous change, along various time horizons. The current study aims at developing a model of endogenous dynamics of activity–travel behavior. Endogenous dynamics are induced by stress, which is regarded as dissatisfaction with current habits. It is assumed that people try to alleviate stress by trying short-term changes, within the options known to them or by exploring new options. If these explorations prove to be unsuccessful, they will consider long-term changes, such as moving to a new residential location, buying a car, etc. Therefore, this self-improvement process can result in both short and long-term adaptations. In the proposed framework, choice-set formation is modeled, the key concepts of aspiration, activation, awareness and expected utility are integrated, while both rational and emotional mechanisms are taken into account. Numerical simulations are conducted in order to check the face validity of the model, as well as the impact of stress tolerance parameters on system performance.

This paper extends Longstaff and Piazzesi (2004, Journal of Financial Economics, 74, 401–421.) to a habit formation model. By combining corporate fraction ratio, and surplus consumption ratio, we derive closed-form solutions for stock values when dividends, habit ratio and consumption follow exponential affine jump-diffusion processes. We can prove that Longstaff and Piazzesi (2004) is only a special case of our model. In addition, calibrated results show that the corporate fraction and habit ratio to shocks significantly increases the equity premium and decreases the risk-free rate. The model determines realistic values for the equity premium and the risk-free rate.

In this chapter, we propose a novel model to incorporate prospect theory into the consumption-based asset pricing model, where habit formation of consumption is employed to determine endogenously the reference point. Our model is motivated by the common element of prospect theory and habit formation of consumption that investors care little about the absolute level of wealth (consumption), but rather pay attention to gains or losses (excess or shortage in consumption level) compared to a reference point. The results show that if investors evaluate their excess or shortage amounts in consumption relative to their habit consumption levels based on prospect theory, the equity premium puzzle can be resolved.