In this paper, I show that an extension of CCAPM
that incorporates the idea of limited participation and
the time-varying and predictable nature of labor's share of output
goes a long way toward explaining several empirical regularities
in asset pricing, including the equity premium puzzle, the riskfree rate
puzzle, the equity volatility puzzle, and the time-varying and predictable
nature of asset returns.
The structure of the model is such that the aggregate labor income
can be interpreted as the habit stock of aggregate consumption. Under
this interpretation, our model nests several popular habit formation
models in the asset pricing literature. Since the aggregate labor
income growth rate is locally stochastic and arbitrarily correlated with
the aggregate consumption growth rate, our model gives rise to a
realistic model of the real term structure.