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S-shaped utility, subprime crash and the black swan

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  • de Farias Neto, Joao Jose

Abstract

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.

Suggested Citation

  • de Farias Neto, Joao Jose, 2008. "S-shaped utility, subprime crash and the black swan," MPRA Paper 12122, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:12122
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    References listed on IDEAS

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    More about this item

    Keywords

    financial puzzles; subprime crash; black swan; S-shaped utility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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