Asset Return Dynamics under Habits and Bad Environment-Good Environment Fundamentals

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 consumption growth and fits standard salient features of asset prices including the means and volatilities of equity returns and a low risk-free rate. BEGE dynamics additionally allow the model to generate realistic properties of equity index options prices and their comovements with the macroeconomic outlook. In particular, when option-implied volatility is highas measured, for instance, by the VIX indexthe distribution of consumption growth is more negatively skewed.