Money and Stock Returns: Is there habit formation for holding liquid assets?

ABSTRACT Assuming a utility function, which is non-separable in money and consumption, we derive a simple, non-linear asset pricing model, according to which investors’ willingness to hold liquid assets in their portfolio can be described by a sort of habit formation. The parameters of the empirical model derived from our theoretical model are estimated with the Smooth Transition Regression (STR) models for the US data. The results of our econometric exercise to test the hypothesis of habit formation remain mixed, but we find evidence, which supports some existing, related attempts to explain stock returns by the liquidity of the economy relative to investors’ target level for liquidity. KEY WORDS: asset pricing models, liquidity. JEL Classification: E44, E51, G12