By incorporating habit formation into an overlapping-generations economy, we show that the middle-aged consumers’ savings decision has a substantial impact on the equity premium. The higher incentive for savings for the middle-aged, resulting from the habit formation preference, causes an even higher demand for bonds and a lower demand for equity, which eventually generates a lower risk-free rate and a higher required return for holding equity than does the framework of non-habit forming models. Calibration results verify that the habit formation setting, together with an OLG framework is capable of yielding lower bond returns and higher equity returns than the standard CRRA utility models, and the borrowing constraint imposed on the young-aged consumers amplifies the positive effect of habit formation on the equity premium. The findings imply that habit formation preferences within the overlapping-generations framework under the borrowing-constrained economy can provide a more improved explanation of the equity premium puzzle.

We investigate the profitability of technical trading strategies based on an asymmetric reverting property of stock returns. We identify an asymmetry in return dynamics for daily returns on the S&P 500 index. Return dynamics evolve along a positive (negative) unconditional mean after a prior positive (negative) return. The trading strategies based on this asymmetry generate a positive return for buy signals, a negative return for sell signals, and a positive return for the spread between buy and sell signals. Our results imply that the observed asymmetry in return dynamics is the main source of profitability for the implied strategies, thereby corroborating arguments for the usefulness of technical trading strategies.

This paper investigates the uneven mean reverting pattern of monthly return indexes of the NYSE, AMEX and NASDAQ, using asymmetric non-linear smooth-transition (ANST) GARCH models. It also evaluates the extent to which time-varying volatility in the index returns support the stock market overreaction hypothesis. The models illuminate patterns of asymmetric mean reversion and risk decimation. Between 1926:01 and l997:12, not only did negative returns reverse to positive returns quicker than positive returns reverted to negative ones, but negative returns, in fact, reduced risk premiums from predictable high volatility. The findings support the market overreaction hypotheses. The asymmetry is due to the mispricing behavior on the part of investors who overreact to certain market news. The findings also corroborate arguments for the “contrarian” portfolio strategy.