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On the consequences of state dependent preferences for the pricing of financial assets

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  • Danthine, Jean-Pierre
  • Donaldson, John B.
  • Giannikos, Christos
  • Guirguis, Hany

Abstract

This Paper introduces state dependent utility into the standard Mehra and Prescott (1985) economy by allowing the representative agent’s coefficient of relative risk aversion to vary with the underlying economy’s growth rate. Existence of equilibrium is proved and its asymptotic properties analysed. This generalization leads to level dependent marginal rates of substitution, a property that sharply distinguishes this model from the standard construct. For very low coefficients of relative risk aversion, the equilibrium risk free and risky security returns are demonstrated to have volatilities and an associated equity premium that substantially exceed what is found in the data. This provides a contrasting perspective on the classic ‘equity premium puzzle.’

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Bibliographic Info

Article provided by Elsevier in its journal Finance Research Letters.

Volume (Year): 1 (2004)
Issue (Month): 3 (September)
Pages: 143-153

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Handle: RePEc:eee:finlet:v:1:y:2004:i:3:p:143-153

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

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References

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  1. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  2. Isen, Alice M. & Geva, Nehemia, 1987. "The influence of positive affect on acceptable level of risk: The person with a large canoe has a large worry," Organizational Behavior and Human Decision Processes, Elsevier, vol. 39(2), pages 145-154, April.
  3. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  4. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  5. Rajnish Mehra & Raaj Sah, 1999. "Can Small Fluctuations in Investors' Subjective Preferences Induce Large Volatility in Equity Prices?," Working Papers 9917, Harris School of Public Policy Studies, University of Chicago.
  6. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  7. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Working Papers melino-03-01, University of Toronto, Department of Economics.
  8. Antoni Bosch-Domènech & Joaquim Silvestre, 1999. "Does risk aversion or attraction depend on income? An experiment," Economics Working Papers 361, Department of Economics and Business, Universitat Pompeu Fabra, revised Mar 1999.
  9. 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.
  10. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  11. Nygren, Thomas E. & Isen, Alice M. & Taylor, Pamela J. & Dulin, Jessica, 1996. "The Influence of Positive Affect on the Decision Rule in Risk Situations: Focus on Outcome (and Especially Avoidance of Loss) Rather Than Probability," Organizational Behavior and Human Decision Processes, Elsevier, vol. 66(1), pages 59-72, April.
  12. Antonio Falato, 2003. "Happiness Maintenance and Asset Prices," Finance 0310003, EconWPA.
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Citations

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Cited by:
  1. Kraus, Alan & Sagi, Jacob S., 2006. "Asset pricing with unforeseen contingencies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 417-453, November.
  2. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.
  3. Pascal St-Amour, 2004. "Ratchet vs Blasé Investors and Asset Markets," CIRANO Working Papers 2004s-11, CIRANO.
  4. Felix Kubler & Karl Schmedders, 2007. "Non-parametric counterfactual analysis in dynamic general equilibrium," PIER Working Paper Archive 07-027, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  5. Miroslav Misina, 2003. "What Does the Risk-Appetite Index Measure?," Working Papers 03-23, Bank of Canada.
  6. Jaime A. Londo\~no, 2006. "State Dependent Utility," Papers math/0603316, arXiv.org.
  7. Miroslav Misina, 2005. "Risk Perceptions and Attitudes," Working Papers 05-17, Bank of Canada.
  8. Dominique Pepin, 2011. "Instabilité des comportements et cycles financiers : une relecture dans un cadre rationnel avec préférences endogènes," Working Papers hal-00960012, HAL.
  9. Antonio Falato, 2008. "Happiness maintenance and asset prices," Finance and Economics Discussion Series 2008-19, Board of Governors of the Federal Reserve System (U.S.).
  10. Falato, Antonio, 2009. "Happiness maintenance and asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1247-1262, June.

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