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Aggregate stock market behavior and investors' low risk aversion

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  • Li, George
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    Abstract

    This paper studies whether investors' high risk aversion can be avoided in a representative-agent model that is able to explain aggregate stock market behavior in the US financial market. We present a consumption-based asset pricing model with a representative agent who has a 'catching up with the Joneses' preference to show that high risk aversion can be avoided in a representative-agent model that can help explain many of the empirically observed properties of the aggregate stock market return, including the equity premium and risk-free rate puzzles, the predictability of long-horizon stock returns, and the 'leverage effect' in return volatility.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

    Volume (Year): 32 (2008)
    Issue (Month): 7 (July)
    Pages: 2349-2369

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    Handle: RePEc:eee:dyncon:v:32:y:2008:i:7:p:2349-2369

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    Web page: http://www.elsevier.com/locate/jedc

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    1. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
    2. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    3. Campbell, John Y., 1999. "Asset prices, consumption, and the business cycle," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 19, pages 1231-1303 Elsevier.
    4. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
    5. Cochrane, John H., 1991. "Volatility tests and efficient markets : A review essay," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 463-485, June.
    6. Ferson, Wayne E. & Constantinides, George M., 1991. "Habit persistence and durability in aggregate consumption: Empirical tests," Journal of Financial Economics, Elsevier, vol. 29(2), pages 199-240, October.
    7. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
    8. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
    9. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    10. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
    11. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
    12. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
    13. Fabio Trojani & Markus Leippold & Paolo Vanini, 2005. "Learning and Asset Prices under Ambiguous Information," University of St. Gallen Department of Economics working paper series 2005 2005-03, Department of Economics, University of St. Gallen.
    14. Yeung Lewis Chan & Leonid Kogan, 2002. "Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1255-1285, December.
    15. G. William Schwert, 1990. "Why Does Stock Market Volatility Change Over Time?," NBER Working Papers 2798, National Bureau of Economic Research, Inc.
    16. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
    17. Hentschel, Ludger & Campbell, John, 1992. "No News is Good News: An Asymmetric Model of Changing Volatility in Stock Returns," Scholarly Articles 3220232, Harvard University Department of Economics.
    18. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
    19. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    20. David A. Chapman, 1998. "Habit Formation and Aggregate Consumption," Econometrica, Econometric Society, vol. 66(5), pages 1223-1230, September.
    21. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
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