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 fundamentals, and fits standard salient features of asset prices including the means and volatilities of equity returns and a low risk free rate. BEGE dynamics are essential for the model to generate realistic features of the “risk-neutral” conditional density of equity returns, including the variance premium.
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