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Changes in Risk and Asset Prices

  • Harris Schlesinger
  • Christian Gollier

We examine asset prices in a representative-agent model of general equilibrium. Assuming only that individuals are risk averse, we determine conditions on the changes in asset risk that are both necessary and sufficient for the asset price to fall. We show that these conditions neither imply, nor are implied by the conditions for second-degree stochastic dominance. For example, if the payoff on an asset becomes riskier in the sense of second-degree stochastic dominance, the equilibrium price of the asset need not necessarily fall. We further demonstrate how our results can be imbedded into a market that is incomplete in the sense of containing an uninsurable background risk, such as a risk on labor income. We extend our model to show how a miscalibration of the asset risk can lead to a partial explanation of high equity premia (i.e., the "equity premium puzzle").

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 443.

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Date of creation: 2001
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Handle: RePEc:ces:ceswps:_443
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  1. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  2. Gollier, C. & Lindsey, J. & Zeckhauser, R., 1996. "Investment Flexibility and the Acceptance of Risk," Papers 96.421, Toulouse - GREMAQ.
  3. Gollier, C. & Kimball, M.S., 1996. "New Methods in the Classical Economics of Uncertainty: Comparing Risks," Papers 96.412, Toulouse - GREMAQ.
  4. Rothschild, Michael & Stiglitz, Joseph E., 1971. "Increasing risk II: Its economic consequences," Journal of Economic Theory, Elsevier, vol. 3(1), pages 66-84, March.
  5. Georges Dionne & Christian Gollier, 1992. "Comparative Statics Under Multiple Sources of Risk with Applications to Insurance Demand," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 17(1), pages 21-33, June.
  6. Doherty, Neil A & Schlesinger, Harris, 1983. "Optimal Insurance in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 91(6), pages 1045-54, December.
  7. Weil, P., 1991. "Equilibrium Asset Prices with Undiversifiable Labor Income Risk," Harvard Institute of Economic Research Working Papers 1564, Harvard - Institute of Economic Research.
  8. Labadie, Pamela, 1986. "Comparative Dynamics and Risk Premia in an Overlapping Generations Model," Review of Economic Studies, Wiley Blackwell, vol. 53(1), pages 139-52, January.
  9. Philippe Jorion & William N. Goetzmann, 1999. "Global Stock Markets in the Twentieth Century," Journal of Finance, American Finance Association, vol. 54(3), pages 953-980, 06.
  10. Dionne, G. & Eeckhoudt, L., 1990. "Increases in Risk and Linear Payoffs," Cahiers de recherche 9019, Universite de Montreal, Departement de sciences economiques.
  11. Eeckhoudt, Louis & Gollier, Christian, 1995. "Demand for Risky Assets and the Monotone Probability Ratio Order," Journal of Risk and Uncertainty, Springer, vol. 11(2), pages 113-22, September.
  12. Segal, Uzi & Spivak, Avia, 1990. "First order versus second order risk aversion," Journal of Economic Theory, Elsevier, vol. 51(1), pages 111-125, June.
  13. Gollier, Christian & Pratt, John W, 1996. "Risk Vulnerability and the Tempering Effect of Background Risk," Econometrica, Econometric Society, vol. 64(5), pages 1109-23, September.
  14. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  15. Landsberger, Michael & Meilijson, Isaac, 1993. "Mean-Preserving Portfolio Dominance," Review of Economic Studies, Wiley Blackwell, vol. 60(2), pages 479-85, April.
  16. Gollier, Christian & Schlesinger, Harris, 2002. "Changes in risk and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(4), pages 747-760, May.
  17. Gollier Christian, 1995. "The Comparative Statics of Changes in Risk Revisited," Journal of Economic Theory, Elsevier, vol. 66(2), pages 522-535, August.
  18. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
  19. Miles S. Kimball, 1991. "Standard Risk Aversion," NBER Technical Working Papers 0099, National Bureau of Economic Research, Inc.
  20. Hart, Oliver D, 1975. "Some Negative Results on the Existence of Comparative Statics Results in Portfolio Theory," Review of Economic Studies, Wiley Blackwell, vol. 42(4), pages 615-21, October.
  21. Narayana R. Kocherlakota, 1995. "The equity premium: it's still a puzzle," Discussion Paper / Institute for Empirical Macroeconomics 102, Federal Reserve Bank of Minneapolis.
  22. Landsberger, Michael & Meilijson, Isaac, 1990. " A Tale of Two Tails: An Alternative Characterization of Comparative Risk," Journal of Risk and Uncertainty, Springer, vol. 3(1), pages 65-82, March.
  23. Eeckhoudt, Louis & Hansen, Pierre, 1980. "Minimum and Maximum Prices, Uncertainty, and the Theory of the Competitive Firm," American Economic Review, American Economic Association, vol. 70(5), pages 1064-68, December.
  24. Constantinides, George M, 1982. "Intertemporal Asset Pricing with Heterogeneous Consumers and without Demand Aggregation," The Journal of Business, University of Chicago Press, vol. 55(2), pages 253-67, April.
  25. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  26. Black, Jane M & Bulkley, I George, 1989. "A Ratio Criterion for Signing the Effects of an Increase in Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(1), pages 119-30, February.
  27. Diamond, Peter A. & Stiglitz, Joseph E., 1974. "Increases in risk and in risk aversion," Journal of Economic Theory, Elsevier, vol. 8(3), pages 337-360, July.
  28. Kihlstrom, Richard E & Romer, David & Williams, Steve, 1981. "Risk Aversion with Random Initial Wealth," Econometrica, Econometric Society, vol. 49(4), pages 911-20, June.
  29. Meyer, Jack & Ormiston, Michael B, 1985. "Strong Increases in Risk and Their Comparative Statics," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 425-37, June.
  30. Hadar, Josef & Seo, Tae Kun, 1990. "The Effects of Shifts in a Return Distribution on Optimal Portfolios," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(3), pages 721-36, August.
  31. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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