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S-shaped utility, subprime crash and the black swan

  • de Farias Neto, Joao Jose

I propose an S-shaped utility function of consumption which, combined with an heterogeneous agents and external habit setting, fits well the first order moments of the American financial and macroeconomic time series relevant for the equity premium puzzle in the second half of XX century. The average relative risk aversion of the agents remains in the 0-3 range. A "black swan"-kind phenomenon makes two of the 50 years considered (the two oil shocks) responsible for half the average of the stochastic discount factor, thus bringing the annual subjective discount factor to a very low level, around 0.5, which solves the risk-free puzzle. The shape of the relative risk aversion function of consumption suggests an explanation for the 2008 suprime crash akin to the breaking of waves on a beach in a lifecycle overlapping generations model.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 12122.

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Date of creation: 12 Dec 2008
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Handle: RePEc:pra:mprapa:12122
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  1. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  2. Sergiy Gerasymchuk, 2008. "Asset return and wealth dynamics with reference dependent preferences and heterogeneous beliefs," Working Papers 160, Department of Applied Mathematics, Università Ca' Foscari Venezia.
  3. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  4. Rubens Penha Cysne, 2005. "Equity-Premium Puzzle: Evidence From Brazilian Data," Anais do XXXIII Encontro Nacional de Economia [Proceedings of the 33th Brazilian Economics Meeting] 088, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
  5. Neilson, William S, 2002. " Comparative Risk Sensitivity with Reference-Dependent Preferences," Journal of Risk and Uncertainty, Springer, vol. 24(2), pages 131-42, March.
  6. Friedman, Daniel, 1989. "The S-Shaped Value Function as a Constrained Optimum," American Economic Review, American Economic Association, vol. 79(5), pages 1243-48, December.
  7. Nick Netzer, 2009. "Evolution of Time Preferences and Attitudes toward Risk," American Economic Review, American Economic Association, vol. 99(3), pages 937-55, June.
  8. Andrew B. Abel, 2006. "Equity Premia with Benchmark Levels of Consumption: Closed-Form Results," NBER Working Papers 12290, National Bureau of Economic Research, Inc.
  9. Jonathan A. Parker & Christian Julliard, 2004. "Consumption Risk and the Cross-Section of Expected Returns," Working Papers 138, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
  10. Björn Hagströmer & Richard G. Anderson & Jane M. Binner & Thomas Elger & Birger Nilsson, 2007. "Mean-variance vs. full-scale optimization: broad evidence for the U.K," Working Papers 2007-016, Federal Reserve Bank of St. Louis.
  11. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  12. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February.
  13. Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151.
  14. Sergiy Gerasymchuk, 2007. "Mean-Variance Portfolio Selection with Reference Dependent Preferences," Working Papers 150, Department of Applied Mathematics, Università Ca' Foscari Venezia.
  15. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
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