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Changes in Risk and Asset Prices

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  • Harris Schlesinger
  • Christian Gollier

Abstract

We examine asset prices in a representative-agent model of general equilibrium. Assuming only that individuals are risk averse, we determine conditions on the changes in asset risk that are both necessary and sufficient for the asset price to fall. We show that these conditions neither imply, nor are implied by the conditions for second-degree stochastic dominance. For example, if the payoff on an asset becomes riskier in the sense of second-degree stochastic dominance, the equilibrium price of the asset need not necessarily fall. We further demonstrate how our results can be imbedded into a market that is incomplete in the sense of containing an uninsurable background risk, such as a risk on labor income. We extend our model to show how a miscalibration of the asset risk can lead to a partial explanation of high equity premia (i.e., the "equity premium puzzle").

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 443.

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Date of creation: 2001
Date of revision:
Handle: RePEc:ces:ceswps:_443

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Related research

Keywords: Asset pricing; stochastic dominance; equity premium puzzle;

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References

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  1. Weil, Philippe, 1992. "Equilibrium asset prices with undiversifiable labor income risk," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 769-790.
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  3. Black, Jane M & Bulkley, I George, 1989. "A Ratio Criterion for Signing the Effects of an Increase in Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(1), pages 119-30, February.
  4. Gollier, Christian & Lindsey, John & Zeckhauser, Richard J., 1997. "Investment Flexibility and the Acceptance of Risk," Journal of Economic Theory, Elsevier, vol. 76(2), pages 219-241, October.
  5. Miles S. Kimball, 1991. "Standard Risk Aversion," NBER Technical Working Papers 0099, National Bureau of Economic Research, Inc.
  6. Dionne, G. & Eeckhoudt, L., 1990. "Increases in Risk and Linear Payoffs," Cahiers de recherche 9019, Universite de Montreal, Departement de sciences economiques.
  7. Gollier, Christian & Schlesinger, Harris, 2002. "Changes in risk and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(4), pages 747-760, May.
  8. 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.
  9. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
  10. Constantinides, George M, 1982. "Intertemporal Asset Pricing with Heterogeneous Consumers and without Demand Aggregation," The Journal of Business, University of Chicago Press, vol. 55(2), pages 253-67, April.
  11. Diamond, Peter A. & Stiglitz, Joseph E., 1974. "Increases in risk and in risk aversion," Journal of Economic Theory, Elsevier, vol. 8(3), pages 337-360, July.
  12. Dionne, G. & Gollier, C., 1991. "Comparative Statics Under Multiple Sources of Risk with Appllications to Insurance Demand," Cahiers de recherche 9133, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
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  14. Narayana R. Kocherlakota, 1995. "The equity premium: it's still a puzzle," Discussion Paper / Institute for Empirical Macroeconomics 102, Federal Reserve Bank of Minneapolis.
  15. Gollier, C. & Kimball, M.S., 1996. "New Methods in the Classical Economics of Uncertainty: Comparing Risks," Papers 96.412, Toulouse - GREMAQ.
  16. Meyer, Jack & Ormiston, Michael B, 1985. "Strong Increases in Risk and Their Comparative Statics," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 425-37, June.
  17. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  18. Landsberger, Michael & Meilijson, Isaac, 1993. "Mean-Preserving Portfolio Dominance," Review of Economic Studies, Wiley Blackwell, vol. 60(2), pages 479-85, April.
  19. Doherty, Neil A & Schlesinger, Harris, 1983. "Optimal Insurance in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 91(6), pages 1045-54, December.
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  21. Kihlstrom, Richard E & Romer, David & Williams, Steve, 1981. "Risk Aversion with Random Initial Wealth," Econometrica, Econometric Society, vol. 49(4), pages 911-20, June.
  22. Hadar, Josef & Seo, Tae Kun, 1990. "The Effects of Shifts in a Return Distribution on Optimal Portfolios," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(3), pages 721-36, August.
  23. Eeckhoudt, Louis & Hansen, Pierre, 1980. "Minimum and Maximum Prices, Uncertainty, and the Theory of the Competitive Firm," American Economic Review, American Economic Association, vol. 70(5), pages 1064-68, December.
  24. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  25. Gollier Christian, 1995. "The Comparative Statics of Changes in Risk Revisited," Journal of Economic Theory, Elsevier, vol. 66(2), pages 522-535, August.
  26. Landsberger, Michael & Meilijson, Isaac, 1990. " A Tale of Two Tails: An Alternative Characterization of Comparative Risk," Journal of Risk and Uncertainty, Springer, vol. 3(1), pages 65-82, March.
  27. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  28. Eeckhoudt, Louis & Gollier, Christian, 1995. "Demand for Risky Assets and the Monotone Probability Ratio Order," Journal of Risk and Uncertainty, Springer, vol. 11(2), pages 113-22, September.
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Citations

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Cited by:
  1. Jouini, E. & Napp, C., 2008. "On Abel's concept of doubt and pessimism," Journal of Economic Dynamics and Control, Elsevier, vol. 32(11), pages 3682-3694, November.
  2. Osaki, Yusuke, 2007. "Risk and Derivative Price," Risk and Sustainable Management Group Working Papers 151179, University of Queensland, School of Economics.
  3. Jouini, Elyès & Napp, Clotilde, 2008. "On Abel's Concepts of Doubt and Pessimism," Economics Papers from University Paris Dauphine 123456789/198, Paris Dauphine University.
  4. Yoichiro Fujii & Yutaka Nakamura, 2010. "Equity premium under multiple background risks," Economics Bulletin, AccessEcon, vol. 30(2), pages 933-939.
  5. Jokung, Octave, 2013. "Monotonicity of asset price toward higher changes in risk," Economics Letters, Elsevier, vol. 118(1), pages 195-198.
  6. Georges Dionne & Jingyuan Li & Cedric Okou, 2012. "An Extension of the Consumption-based CAPM Model," Cahiers de recherche 1214, CIRPEE.
  7. Masamitsu Ohnishi & Yusuke Osaki, 2005. "The Monotonicity of Asset Prices with Changes in Risk," Discussion Papers in Economics and Business 05-14, Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP).
  8. Harris Schlesinger & Christian Gollier, 2001. "Changes in Risk and Asset Prices," CESifo Working Paper Series 443, CESifo Group Munich.
  9. Masamitsu Ohnishi & Yusuke Osaki, 2004. "The Comparative Statics of Equilibrium Derivative Prices," Discussion Papers in Economics and Business 04-19, Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP).

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