Habit persistence: Explaining cross-sectional variation in returns and time-varying expected returns

This paper uses an iterated GMM approach to estimate and test the consumption based habit persistence model of Campbell and Cochrane [Campbell, J.Y., Cochrane, J.H., 1999. By force of habit: A consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205-251] on the US stock market. The empirical evidence shows that the model is able to explain the size premium, but fails to explain the value premium. Further, the state variable of the model - the surplus consumption ratio - explains counter-cyclical time-varying expected returns on stocks. The model also produces plausible low real risk-free rates despite high relative risk aversion.