evidence of cyclical variation in consumption or dividend volatility that could explain the variation in stock market volatility. A more promising possibility is that the price of risk varies over time.Time-variation in the price of risk arises naturally in a model with a representative agent whose utility displays habit-formation.Campbell and Cochrane (1999),building on the work of Abel (1990), Constantinides (1990),and others,have proposed a simple asset pricing model of this sort. Campbell and Cochrane suggest that assets are priced as if there were a representative agent whose utility is a power function of the difference between consumption and "habit",where habit is a slow-moving nonlinear average of past aggregate consumption.This utility function makes the agent more risk-averse in bad times,when consumption is low relative to its past history,than in good times,when consumption is high relative to its past history.Stock market volatility is explained by a small amount of underlying consumption(dividend)risk, amplified by variable risk aversion;the equity premium is explained by high stock market volatility,together with a high average level of risk aversion. Similar ideas have been put forward in the recent literature on behavioral finance.Kah- neman and Tversky(1979)used experimental evidence to argue that agents behave as if their utility function is kinked at a reference point which is close to the current level of wealth Benartzi and Thaler (1995)argued that Kahneman and Tversky's "prospect theory"could explain the equity premium puzzle if agents frequently evaluate their utility and reset their reference points,so that the kink in utility increases their effective risk aversion.Barberis, Huang,and Santos(2001),building on behavioral evidence of Thaler and Johnson (1990), argue that prospect theory should be extended to make agents effectively less risk averse if their wealth has recently risen,very much in the spirit of a habit-formation model. Time-variation in the price of risk can also arise from the interaction of heterogeneous agents.Constantinides and Duffie(1996)develop a simple framework with many agents who have identical utility functions but heterogeneous streams of labor income;they show how changes in the cross-sectional distribution of income can generate any desired behavior of the market price of risk.Dumas (1989),Grossman and Zhou (1996),Wang (1996),Sandroni 7                '     ( (    ;   %        (      )     (           %      )      A111B#  %   (  ; A11B#  A11B#  #        %         %%            %          J     CD#      ) %   %   %%%       (  %  ()    #           #   %  #     %       "( (     '          %   AB (#      ( >  $    '   % ( (   # %   % %   (  "               F)    ( A131B  '     %  %         ((                =     A118B %  F   (H C   D   '   $      % $           #    ((      J (  =# ?%#  " AB#  %       
 A11B# %        '  ( % J   (         #         )     )     (         % %   &E A119B      (   %        %      >    %   )      %      (   ( &  A141B# +   K A119B# G% A119B# " 3