A Consumption Based Term Structure Model w ith Habit Utility 

Jun Lou^1,2 
(1. Graduate Center, City University of New York, USA; 2. School of Business, SIENA College, USA)

Abstract: This paper proposes a term structure of interest rates model that modifies and extends the Campbell and Cochrane (1999) surplus consumption framework. The distinguishing contributions are tractable, continuous-time analytical solutions for the term structure of interest rate generating a realistic upward sloping yield curve. Despite the focus on the term structure, the model matches plausible equity quantities. For the interest rate, the model is able to account for the moments of bond yields at numerous maturities and produce countercyclical bond risk premia as seen in the data. Moreover, the model captures reasonable time series fluctuation on real interest rates. However, the model has difficulties reproducing empirical deviations from the expectations hypothesis.

Key words: bond risk premia; habit persistence; term structure; surplus consumption

JEL codes: G02, G12, F36, C32