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Happiness maintenance and asset prices

  • Antonio Falato

This paper constructs a simple dynamic asset pricing model which incorporates recent evidence on the influence of immediate emotions on risk preferences. Investors derive direct utility from both consumption and financial wealth and, consistent with the happiness maintenance feature documented by Isen (1999) and others, become more cautious toward their wealth in good times. Mild pro-cyclical changes in risk aversion over wealth cause large pro-cyclical fluctuations in the current price-dividend ratio which, due to general equilibrium restrictions, translate into counter-cyclical variation in the current consumption-wealth ratio and, in turn, in expected future returns. With a realistic consumption growth process and reasonable preference parameters, the model generates a sizable equity premium, a low and stable risk-free rate, volatile and predictable stock returns, and price-dividend and Sharpe ratios in line with the data.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2008-19.

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Date of creation: 2008
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Handle: RePEc:fip:fedgfe:2008-19
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