A model of time-varying risk premia with habits and production Ian Dew-Becker Harvard University

This paper develops a new utility speci\u85cation that incorporates CampbellCochranetype habits into the EpsteinZin class of preferences. In a simple calibration of a real business cycle model with EZ-habit preferences, the model generates a strongly countercyclical equity premium, substantial equity return predictability, and a stable riskless interest rate, as in the data. Moreover, conditional on the average level of risk aversion, time-variation in risk aversion increases the volatility and mean return of equities. On the real side, the model matches the short and long-term variances of output, consumption, and investment growth. As an additional empirical test, I measure implied risk aversion and \u85nd that it has an R2 of over 50 percent for 5-year stock returns in post-war data. Variables that predict stock returns in the data also predict returns in the model with a similar degree of explanatory power.