An Isomorphism Between Asset Pricing Models With and Without Linear Habit Formation

Mark Schroder, Costis Skiadas*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

33 Scopus citations

Abstract

We show an isomorphism between optimal portfolio selection or competitive equilibrium models with utilities incorporating linear habit formation, and corresponding models without habit formation. The isomorphism can be used to mechanically transform known solutions not involving habit formation to corresponding solutions with habit formation. For example, the Constantinides (1990) and Ingersoll (1992) solutions are mechanically obtained from the familiar Merton solutions for the additive utility case, without recourse to a Bellman equation or first-order conditions. More generally, recent solutions to portfolio selection problems with recursive utility and a stochastic investment opportunity set are readily transformed to novel solutions of corresponding problems with utility that combines recursivity with habit formation. The methodology also applies in the context of Hindy-Huang-Kreps (1992) preferences, where our isomorphism shows that the solution obtained by Hindy and Huang (1993) can be mechanically transformed to Dybvig's (1995) solution to the optimal consumption-investment problem with consumption ratcheting.

Original languageEnglish (US)
Pages (from-to)1189-1221
Number of pages33
JournalReview of Financial Studies
Volume15
Issue number4
DOIs
StatePublished - 2002

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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