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Preference heterogeneity and asset prices: An exact solution

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  • Weinbaum, David
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    Abstract

    We introduce a general equilibrium model of a multi-agent, pure-exchange economy and find a set of conditions that enable us to obtain explicit closed-form solutions to the equilibrium interest rate, stock price, risk premium and stock market volatility when investors have heterogenous risk aversions. Because the market is dynamically complete, full risk sharing obtains and a representative agent can be constructed, though the risk aversion of this agent fluctuates over time with the state of the economy, as the relative wealth distribution of the individual investors changes. We show that preference heterogeneity can cause asset prices to be significantly more volatile than the underlying dividends and that it can lead to leverage-like effects in volatility, in the sense that volatility increases after stock-market declines.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 34 (2010)
    Issue (Month): 9 (September)
    Pages: 2238-2246

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    Handle: RePEc:eee:jbfina:v:34:y:2010:i:9:p:2238-2246

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

    Related research

    Keywords: Preference hererogeneity Risk aversion Closed form solution;

    References

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    Cited by:
    1. Marini, François, 2011. "Financial intermediation in the theory of the risk-free rate," Journal of Banking & Finance, Elsevier, vol. 35(7), pages 1663-1668, July.
    2. Nieto, Belén & Rubio, Gonzalo, 2011. "The volatility of consumption-based stochastic discount factors and economic cycles," Journal of Banking & Finance, Elsevier, vol. 35(9), pages 2197-2216, September.

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