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The effect of relative wealth concerns on the cross-section of stock returns

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  • JUAN PEDRO GOMEZ

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    (Instituto de Empresa)

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    Abstract

    There are several economic reasons why investors might want to hedge local risk resulting from relative wealth concerns; namely, keeping up with the Joneses preferences and competition for local assets in short supply. In equilibrium, hedging for these purposes results in a negative risk Premium for the local risk factors. We study the empirical implications of this equilibrium at the level of the nine US census divisions. As a proxy for the local risk factor we use regional labor income growth. In explaining the cross-section of stock returns, the model performs substantially better than the CAPM, and as well as the Fama-French three factor model.

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    File URL: http://latienda.ie.edu/working_papers_economia/WP08-12.pdf
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    Bibliographic Info

    Paper provided by Instituto de Empresa, Area of Economic Environment in its series Working Papers Economia with number wp08-12.

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    Length: 28 pages
    Date of creation: Feb 2008
    Date of revision:
    Handle: RePEc:emp:wpaper:wp08-12

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    Keywords: Local risk; Negative risk premium; Relative wealth concerns;

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    1. Ravi Jagannathan & Zhenyu Wang, 1996. "The conditional CAPM and the cross-section of expected returns," Staff Report 208, Federal Reserve Bank of Minneapolis.
    2. Charles Brown & James L. Medoff, 1989. "The Employer Size-Wage Effect," NBER Working Papers 2870, National Bureau of Economic Research, Inc.
    3. Peter M. DeMarzo & Ron Kaniel & Ilan Kremer, 2008. "Relative Wealth Concerns and Financial Bubbles," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 19-50, January.
    4. Gali, Jordi, 1994. "Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice, and Asset Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(1), pages 1-8, February.
    5. Jonathan Berk & Richard C. Green & Vasant Naik, 1998. "Optimal Investment, Growth Options, and Security Returns," NBER Working Papers 6627, National Bureau of Economic Research, Inc.
    6. Harrison Hong & Jeffrey D. Kubik & Jeremy C. Stein, 2005. "The Only Game in Town: Stock-Price Consequences of Local Bias," NBER Working Papers 11488, National Bureau of Economic Research, Inc.
    7. Peter M. Demarzo & Ron Kaniel & Ilan Kremer, 2004. "Diversification as a Public Good: Community Effects in Portfolio Choice," Journal of Finance, American Finance Association, vol. 59(4), pages 1677-1716, 08.
    8. Huberman, Gur, 2001. "Familiarity Breeds Investment," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 659-80.
    9. Martin Lettau & Sydney Ludvigson, 2001. "Resurrecting the (C)CAPM: A Cross-Sectional Test When Risk Premia Are Time-Varying," Journal of Political Economy, University of Chicago Press, vol. 109(6), pages 1238-1287, December.
    10. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
    11. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, 02.
    12. Joshua D. Coval & Tobias J. Moskowitz, 1999. "Home Bias at Home: Local Equity Preference in Domestic Portfolios," Journal of Finance, American Finance Association, vol. 54(6), pages 2045-2073, December.
    13. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
    14. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
    15. Gomez, Juan-Pedro, 2007. "The impact of keeping up with the Joneses behavior on asset prices and portfolio choice," Finance Research Letters, Elsevier, vol. 4(2), pages 95-103, June.
    16. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
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