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On the Consequences of State Dependent Preferences for the Pricing of Financial Assets

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Author Info

  • Jean-Pierre Danthine
  • John B. Donaldson
  • Christos Giannikos
  • Hany Guirguis

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 analyzed. 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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Bibliographic Info

Paper provided by Université de Lausanne, Faculté des HEC, DEEP in its series Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) with number 02.17.

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Length: 33 pp.
Date of creation: Oct 2002
Date of revision:
Handle: RePEc:lau:crdeep:02.17

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Postal: Université de Lausanne, Faculté des HEC, DEEP, Internef, CH-1015 Lausanne
Phone: ++41 21 692.33.64
Fax: ++41 21 692.33.05
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Web page: http://www.hec.unil.ch/deep/publications/cahiers/series
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Keywords: state dependent utility; equity premium; equity premium puzzle;

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References

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  1. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  2. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  3. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  4. 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.
  5. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  6. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  7. 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.
  8. Rajnish Mehra & Raaj Sah, 1999. "Can Small Fluctuations in Investors' Subjective Preferences Induce Large Volatility in Equity Prices?," Working Papers 9917, Harris School of Public Policy Studies, University of Chicago.
  9. Antonio Falato, 2003. "Happiness Maintenance and Asset Prices," Finance 0310003, EconWPA.
  10. 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.
  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.
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Citations

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Cited by:
  1. Falato, Antonio, 2009. "Happiness maintenance and asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1247-1262, June.
  2. Kraus, Alan & Sagi, Jacob S., 2006. "Asset pricing with unforeseen contingencies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 417-453, November.
  3. Miroslav Misina, 2003. "What Does the Risk-Appetite Index Measure?," Working Papers 03-23, Bank of Canada.
  4. 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.).
  5. Felix Kubler & Karl Schmedders, 2010. "Non-parametric counterfactual analysis in dynamic general equilibrium," Economic Theory, Springer, vol. 45(1), pages 181-200, October.
  6. Miroslav Misina, 2005. "Risk Perceptions and Attitudes," Working Papers 05-17, Bank of Canada.
  7. Jaime A. Londo\~no, 2006. "State Dependent Utility," Papers math/0603316, arXiv.org.
  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. Pascal St-Amour, 2004. "Ratchet vs Blasé Investors and Asset Markets," CIRANO Working Papers 2004s-11, CIRANO.
  10. 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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