Habit Formation and Risk-free Rate Puzzle

Abstract

This paper deals with risk-free rate puzzle when the agent shows external habit formation, using different sorts of instruments that are used for proxies as a risk-free rate. It is found that upon instruments, risk free rate puzzle is vulnerable to the proxies selected; this fact ascribes to the partial solution to that puzzle. In addition, the external habit ratio model in contrast with time separable preferences exclusively contributes to the description of observed behavior of secular instruments. In particular, the degree of time-nonseparability of the former plays a remarkable role in solving out the discrepancy between observed and derived rate, lowering theoretical interest rate into the bottom of observed rate within reasonable risk aversion.