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Evidence for countercyclical risk aversion: an experiment with financial professionals

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  • Alain Cohn
  • Jan Engelmann
  • Ernst Fehr
  • Michel Maréchal

Abstract

A key ingredient of many popular asset pricing models is that investors exhibit countercyclical risk aversion, which helps explain major puzzles in financial economics such as the strong and systematic variation in risk premiums over time and the high volatility of asset prices. There is, however, surprisingly little evidence for this assumption because it is difficult to control for the host of factors that change simultaneously during financial booms and busts. We circumvent these control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes. Subjects who were primed with a financial bust were substantially more risk averse than those who were primed with a boom. Subjects were also more fearful in the bust than in the boom condition, and their fear is negatively related to investments in the risky asset, suggesting that fear may play an important role in countercyclical risk aversion. The mechanism described in this paper is relevant for theory and has important implications for financial markets, as it provides the basis for a self-reinforcing process that amplifies market dynamics.

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Bibliographic Info

Paper provided by UBS International Center of Economics in Society - Department of Economics - University of Zurich in its series UBSCENTER - Working Papers with number 004.

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Date of creation: Aug 2013
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Handle: RePEc:zur:uceswp:004

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Keywords: Countercyclical risk aversion; experiment; financial professionals;

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References

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Cited by:
  1. Tai-Sen HE & Fuhai HONG, 2014. "Exposure to Risk and Risk Aversion: A Laboratory Experiment," Economic Growth centre Working Paper Series 1403, Nanyang Technolgical University, School of Humanities and Social Sciences, Economic Growth centre.

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