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Expectations-Based Reference-Dependent Preferences and Asset Pricing

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  • Pagel, Michaela

Abstract

This paper incorporates expectations-based reference-dependent preferences into the canonical Lucas-tree asset-pricing economy. Expectations-based loss aversion increases the equity premium and decreases the consumption-wealth ratio, because uncertain fluctuations in consumption are perceived to be more painful. Moreover, because unexpected cuts in consumption are particularly painful, the agent wants to postpone such cuts to let his reference point decrease. Thus, even though shocks are i.i.d., loss aversion induces variation in the consumption-wealth ratio, which generates variation in the equity premium, expected returns, and predictability. The level and variation in the equity premium and the predictability in returns match historical moments, but the associated variation in intertemporal substitution motives results in excessive variation in the risk-free rate. This effect can be partially offset with variation in expected consumption growth, heteroskedasticity in consumption growth, or time-variant disaster risk. As a key contribution, I show that the preferences resolve the equity-premium puzzle and simultaneously imply plausible risk attitudes towards small and large wealth bets.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 47933.

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Date of creation: Dec 2012
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Handle: RePEc:pra:mprapa:47933

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Keywords: expectations-based reference-dependent preferences; asset pricing; equity-premium puzzle; predictability;

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References

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Cited by:
  1. Driscoll, John C. & Holden, Steinar, 2014. "Behavioral Economics and Macroeconomic Models," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2014-43, Board of Governors of the Federal Reserve System (U.S.).
  2. Nicholas C. Barberis, 2012. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," NBER Working Papers 18621, National Bureau of Economic Research, Inc.
  3. Nicholas C. Barberis, 2013. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 27(1), pages 173-96, Winter.
  4. Pagel, Michaela, 2013. "Expectations-Based Reference-Dependent Life-Cycle Consumption," MPRA Paper 47138, University Library of Munich, Germany.

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