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Asset-Pricing Implications of Biologically Based Non-Expected Utility

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  • Emil Iantchev

    (Syracuse University)

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    Abstract

    Results in population ecology suggest that evolutionary successful species should have an adaptive (reference-based) S-shaped utility function that is intrinsically more sensitive to aggregate than uninsured idiosyncratic shocks--the former cannot be diversified demographically. To test the asset-pricing relevance of these ideas, I embed the non-expected utility specification implied by evolutionary theory into an economy with partial risk sharing due to limited commitment. For the benchmark specification (CRRA=6 over gains), Monte Carlo simulations of a Markov growth economy produce the following results: (i) matching the degree of consumption-smoothing in the cross section, the Sharpe ratio for a Lucas tree is 0.33, an increase of 44 percent relative to expected utility; (ii) the risk-free rate is low, stable and counter cyclical, hence equity returns, unlike in the expected utility case, have the correct pattern of predictability; (iii) in the cross section, excess returns across equity classes exhibit both a value premium and a size discount with risk adjusted returns that are at least two times higher than their expected utility counterparts. (Copyright: Elsevier)

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    File URL: http://dx.doi.org/10.1016/j.red.2012.08.002
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    Bibliographic Info

    Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

    Volume (Year): 16 (2013)
    Issue (Month): 3 (July)
    Pages: 497-510

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    Handle: RePEc:red:issued:11-255

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    Related research

    Keywords: Recursive utility; Limited commitment; Equity return predictability; Cross-sectional distribution of equity returns;

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