Asset Pricing with Endogenous Beliefs-Dependent Risk Aversion

I present an economy where aggregate risk aversion is stochastic, exogenous, and beliefs-dependent. The preferences are conditionally isoelastic álaGordon and St-Amour (2004). Representative consumer forms expectations about aggregate aversion to growth states’ uncertainty and makes beliefs-contingent consumption and investment decisions. The consumer is rewarded for preferences risk in addition to consumption risk. The consumer’s attitudes toward uncertainty about the business cycle are countercyclical, mildly volatile, with volatility clustering in periods of economic bust. When evaluated on cross-sections of stock returns, the model generates economically small unconditional Euler errors. This article presents new evidence that conditioning on a data rich information filtration leads to substantial pricing improvements. There is increased volatility and clustering around recessions in information poor environment.