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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, Chrisos
  • 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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3697.

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Date of creation: Jan 2003
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Handle: RePEc:cpr:ceprdp:3697

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Keywords: equity premium; equity premium puzzle; state dependent utility;

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  1. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. 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.
  3. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  4. 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.
  5. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  6. 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.
  7. Mehra, Rajnish & Sah, Raaj, 2002. "Mood fluctuations, projection bias, and volatility of equity prices," Journal of Economic Dynamics and Control, Elsevier, vol. 26(5), pages 869-887, May.
  8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  9. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  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. 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.
  12. Antonio Falato, 2003. "Happiness Maintenance and Asset Prices," Finance 0310003, EconWPA.
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Cited by:
  1. Miroslav Misina, 2003. "What Does the Risk-Appetite Index Measure?," Working Papers 03-23, Bank of Canada.
  2. 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.).
  3. Felix KUBLER & Karl SCHMEDDERS, . "Non-parametric counterfactual analysis in dynamic general equilibrium," Swiss Finance Institute Research Paper Series 09-05, Swiss Finance Institute.
  4. Dominique Pepin, 2011. "Instabilité des comportements et cycles financiers : une relecture dans un cadre rationnel avec préférences endogènes," Working Papers hal-00960012, HAL.
  5. Jaime A. Londo\~no, 2006. "State Dependent Utility," Papers math/0603316, arXiv.org.
  6. Kraus, Alan & Sagi, Jacob S., 2006. "Asset pricing with unforeseen contingencies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 417-453, November.
  7. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.
  8. Miroslav Misina, 2005. "Risk Perceptions and Attitudes," Working Papers 05-17, Bank of Canada.
  9. Pascal St-Amour, 2004. "Ratchet vs Blasé Investors and Asset Markets," CIRANO Working Papers 2004s-11, CIRANO.
  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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