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Can Small Fluctuations in Investors' Subjective Preferences Induce Large Volatility in Equity Prices?

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  • Rajnish Mehra
  • Raaj Sah

Abstract

This paper focuses on the potential effects of small fluctuations in investors' subjective preferences (specifically, their discount factors and attitudes towards risk) on the volatility of equity prices. We briefly summarize some of the arguments and evidence regarding the fluctuations in subjective preferences. Our analysis indicates that such fluctuations may have significant implications for understanding the volatility of the prices of financial assets. We derive a closed-form expression for equilibrium equity prices, and use this expression to map the fluctuations in investors' subjective preferences to the fluctuations in equity prices. Our analysis suggests that small fluctuations in the discount factor have potentially large effects on the latter. For example, if the standard deviation of the fluctuations in the discount factor is of the order of 1/10th of one percent, then this by itself can induce a 3 to 4% standard deviation in the fluctuations in equity prices. The fluctuations in the attitude towards risk have a smaller, but nevertheless non-negligible effect. We present the intuition underlying our conclusions.

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Bibliographic Info

Paper provided by Harris School of Public Policy Studies, University of Chicago in its series Working Papers with number 9917.

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Date of creation: Sep 1999
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Handle: RePEc:har:wpaper:9917

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Keywords: equity prices; volatility; discount factor; risk;

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  1. George Loewenstein & Ted O'Donoghue & Matthew Rabin, 2003. "Projection Bias In Predicting Future Utility," The Quarterly Journal of Economics, MIT Press, vol. 118(4), pages 1209-1248, November.
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Citations

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Cited by:
  1. Levy, Tamir & Yagil, Joseph, 2011. "Air pollution and stock returns in the US," Journal of Economic Psychology, Elsevier, vol. 32(3), pages 374-383, June.
  2. GARCIA,René & LUGER, Richard & RENAULT, Éric, 2001. "Empirical Assessment of an Intertemporal Option Pricing Model with Latent variables," Cahiers de recherche 2001-10, Universite de Montreal, Departement de sciences economiques.
  3. Daskalakis, George & Symeonidis, Lazaros & Markellos, Raphael, 2009. "Does the weather affect stock market volatility?," MPRA Paper 34128, University Library of Munich, Germany.
  4. Mamatzakis, E, 2013. "Does weather affect US bank loan efficiency?," MPRA Paper 51616, University Library of Munich, Germany.
  5. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.
  6. David Havlíček, 2010. "Analysis of the Impact of Weather on Trading in Equity Markets," Český finanční a účetní časopis, University of Economics, Prague, vol. 2010(3), pages 49-62.
  7. Kaplanski, Guy & Levy, Haim, 2010. "Sentiment and stock prices: The case of aviation disasters," Journal of Financial Economics, Elsevier, vol. 95(2), pages 174-201, February.
  8. 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.
  9. Kliger, Doron & Kudryavtsev, Andrey, 2013. "Volatility expectations and the reaction to analyst recommendations," Journal of Economic Psychology, Elsevier, vol. 37(C), pages 1-6.
  10. Cao, Melanie & Wei, Jason, 2005. "Stock market returns: A note on temperature anomaly," Journal of Banking & Finance, Elsevier, vol. 29(6), pages 1559-1573, June.
  11. 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.).
  12. Antonio Falato, 2003. "Happiness Maintenance and Asset Prices," Finance 0310003, EconWPA.
  13. Higashi, Youichiro & Hyogo, Kazuya & Takeoka, Norio, 2009. "Subjective random discounting and intertemporal choice," Journal of Economic Theory, Elsevier, vol. 144(3), pages 1015-1053, May.
  14. McLeish, Kendra N. & Oxoby, Robert J., 2007. "Gender, Affect and Intertemporal Consistency: An Experimental Approach," IZA Discussion Papers 2663, Institute for the Study of Labor (IZA).
  15. Falato, Antonio, 2009. "Happiness maintenance and asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1247-1262, June.
  16. Kraus, Alan & Sagi, Jacob S., 2006. "Asset pricing with unforeseen contingencies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 417-453, November.

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