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Rational Inattention, Portfolio Choice, and the Equity Premium

  • Yulei Luo

    ()

    (School of Economics and Finance, University of Hong Kong)

This paper explores how the introduction of Rational Inattention (RI) affects optimal consumption and portfolio rules and asset pricing in the consumption-based CAPM framework. I first solve an otherwise standard portfolio choice and asset pricing model with RI explicitly and show that RI can generate smooth consumption process and low contemporaneous correlation between consumption growth and asset returns. Second, it is shown that in the RI economy asset returns are determined by the ultimate consumption risk rather than the contemporaneous risk. As a result, RI has a potential to reduce the demand for the risky asset and could endo- genize limited stock market participation hypothesis. Third, I show that RI can disentangle the coefficient of relative risk aversion with the elasticity of intertemporal substitution endoge- neously by increasing the effective CRRA. RI can therefore be an alternative explanation for the equity premium puzzle and the risk free rate puzzle. Fourth, I compare RI with recursive preference, robustness, and habit formation. Fifth, I investigate the implications of RI for optimal consumption and portfolio choice when investment opportunities are stochastic and labor income is modelled explicitly. Finally, I propose a general equilibrium asset pricing framework to examine the implications of RI for the equity premium, the mean ratio of price to dividend, and the equity volatility in equilibrium.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 56.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:56
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