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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.?

Suggested Citation

  • Danthine, Jean-Pierre & Donaldson, John B & Giannikos, Chrisos & Guirguis, Hany, 2003. "On the Consequences of State Dependent Preferences for the Pricing of Financial Assets," CEPR Discussion Papers 3697, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:3697
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    8. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
    9. Danthine, Jean-Pierre & Donaldson, John B. & Giannikos, Christos & Guirguis, Hany, 2004. "On the consequences of state dependent preferences for the pricing of financial assets," Finance Research Letters, Elsevier, vol. 1(3), pages 143-153, September.
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    1. Danthine, Jean-Pierre & Donaldson, John B. & Giannikos, Christos & Guirguis, Hany, 2004. "On the consequences of state dependent preferences for the pricing of financial assets," Finance Research Letters, Elsevier, vol. 1(3), pages 143-153, September.
    2. Luz Rocío Sotomayor & Abel Cadenillas, 2009. "Explicit Solutions Of Consumption‐Investment Problems In Financial Markets With Regime Switching," Mathematical Finance, Wiley Blackwell, vol. 19(2), pages 251-279, April.
    3. Falato, Antonio, 2009. "Happiness maintenance and asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1247-1262, June.
    4. Pascal St-Amour, 2004. "Ratchet vs Blasé Investors and Asset Markets," CIRANO Working Papers 2004s-11, CIRANO.
    5. Miroslav Misina, 2003. "What does the risk-appetite index measure?," Economics Bulletin, AccessEcon, vol. 28(6), pages 1-6.
    6. Miroslav Misina, 2005. "Risk Perceptions and Attitudes," Staff Working Papers 05-17, Bank of Canada.
    7. Luiz Vitiello & Ser-Huang Poon, 2022. "Option pricing with random risk aversion," Review of Quantitative Finance and Accounting, Springer, vol. 58(4), pages 1665-1684, May.
    8. Dominique Pepin, 2011. "Instabilité des comportements et cycles financiers : une relecture dans un cadre rationnel avec préférences endogènes," Working Papers hal-00960012, HAL.
    9. Traian A. Pirvu & Huayue Zhang, 2012. "A Multi Period Equilibrium Pricing Model," Papers 1205.6193, arXiv.org.
    10. Jaime A. Londo~no, 2006. "State Dependent Utility," Papers math/0603316, arXiv.org.
    11. Felix Kubler & Karl Schmedders, 2010. "Non-parametric counterfactual analysis in dynamic general equilibrium," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 45(1), pages 181-200, October.
    12. Dominique Pépin & Stephen M. Miller, 2020. "The Time-Varying Nature of Risk Aversion: Evidence from 60 Years of U.S. Stock Market Data," Working papers 2020-09, University of Connecticut, Department of Economics.
    13. Amadeu DaSilva & Mira Farka & Christos Giannikos, 2011. "Habit Formation in an Overlapping Generations Model with Borrowing Constraints," European Financial Management, European Financial Management Association, vol. 17(4), pages 705-725, September.
    14. Kraus, Alan & Sagi, Jacob S., 2006. "Asset pricing with unforeseen contingencies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 417-453, November.
    15. Berrada, Tony & Detemple, Jérôme & Rindisbacher, Marcel, 2018. "Asset pricing with beliefs-dependent risk aversion and learning," Journal of Financial Economics, Elsevier, vol. 128(3), pages 504-534.
    16. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    State dependent utility; Equity premium; Equity premium puzzle;
    All these keywords.

    JEL classification:

    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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