A Consumption-Based Term Structure Model of Bond and Equity

In this study, I propose a consumption-based asset pricing model to capture the dynamic properties of term structures of bond and equity. I extend the long-run risks model by introducing a mean-reversion of dividend growth and external habit formation of a representative agent. The mean-reverting dividend growth generates negative equity term premium, while the habit formation augments the equity premium and renders an upward-sloping bond yield curve, on average. In addition, fluctuations in the surplus consumption ratio and conditional variance of consumption growth allow the model to reproduce pro-cyclical variations in bond and equity yield spreads and counter-cyclical variations in bond and equity term premiums, as observed in the U.S. data