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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. 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.
    2. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
    3. 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.
    4. Hong, Harrison & Kubik, Jeffrey D. & Stein, Jeremy C., 2008. "The only game in town: Stock-price consequences of local bias," Journal of Financial Economics, Elsevier, vol. 90(1), pages 20-37, October.
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    6. Gali, J., 1992. "Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice and Asset Prices," Papers 92-22, Columbia - Graduate School of Business.
    7. 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.
    8. Jonathan Berk & Richard C. Green & Vasant Naik, . "Optimal Investment, Growth Options and Security Returns," GSIA Working Papers 64, Carnegie Mellon University, Tepper School of Business.
    9. 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.
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    11. Charles Brown & James L. Medoff, 1989. "The Employer Size-Wage Effect," NBER Working Papers 2870, National Bureau of Economic Research, Inc.
    12. Ravi Jagannathan & Zhenyu Wang, 1996. "The conditional CAPM and the cross-section of expected returns," Staff Report 208, Federal Reserve Bank of Minneapolis.
    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. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, 02.
    15. Huberman, Gur, 2001. "Familiarity Breeds Investment," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 659-80.
    16. 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.
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