Asset Return Dynamics Under Habits and Bad-Environment-Good Environment Fundamentals

We introduce a “bad environment-good environment” (BEGE) technology for consumption growth in a consumption-based asset pricing model with external habit formation. The model generates realistic non-Gaussian features of consumption growth and fits standard salient features of asset prices including the means and volatilities of equity returns and a low risk free rate. BEGE dynamics additionally allow the model to generate realistic properties of equity index options prices, and their comovements with the macroeconomic outlook. In particular, when option-implied volatility is high, as measured for instance by the VIX index, the distribution of consumption growth is more negatively skewed