Substitution, risk aversion, taste shocks and equity premia (original) (raw)

Countercyclical and Time-Varying Risk Aversion and Equity Premium

SSRN Electronic Journal, 2016

This paper tests the counter-cyclicality of aggregate risk aversion and price of market risk using a novel testing approach introduced in Antell and Vaihekoski (2015) for conditional asset pricing models. Cohen et al. (2015) report experimental evidence that the risk aversion is countercyclical, although empirical support from financial studies is at best inconclusive. This paper applies the new testing approach for the Merton (1973, 1980) model. The testable implications link the realized equity premium to, among others, changes in conditional variance, its long-term persistence, and changes in the time-varying risk aversion. Empirically, the testing is conducted using monthly US stock market data from 1928 to 2013, and GARCH models to estimate time-varying variance. Various methods to model economic expectations are compared. Unlike the traditional estimation approach, the results from the new estimation approach give clear support for time-varying and countercyclical risk aversion.

Essays in Empirical Asset Pricing

Thesis Columbia University 2007, 2007

This dissertation consists of two chapters, all of which attempt to shed some light on what constitutes the time-varying risk premia in financial markets. The first chapter demonstrates that monetary policy shocks identified from New-Keynesian dynamic stochastic general equilibrium(DSGE) models explain the risk premia in stock markets. Indeed, the implied ICAPMs explain the value and the industry premia for the periods of 1980 to 2004. In particular, the permanent monetary policy shocks to inflation target capture the value premium and part of industry risk premium once I account for the capital market imperfection endogenously in New-Keynesian models. The shocks to investment technology, as a main determinant of the external finance premium, are also important for understanding the value premium. The second chapter examines determinants of stochastic relative risk aversion in conditional asset pricing models by utilizing nonlinear state space model with GARCH specification. After imposing general version of the conditional CAPM or ICAPM, I develop non-ad-hoc empirical models and search for valid specifications of relative risk aversion along with appropriate hedging components. I discover that the surplus consumption ratio implied by the external habit formation model is the most important determinant of time varying relative risk aversion. The CAY of Lettau and Ludvigson (2001a) without a lookahead bias also captures part of relative risk aversion. The short term interest rate(RREL) has explanatory power for hedging components. I use the implied conditional asset pricing models in explaining the cross-section of average returns on either the Fama-French 25 size and book-to-market sorted portfolios alone or with 30 industry portfolios. I find that the chosen conditional CAPM and ICAPM with time-varying relative risk aversion and a hedging component are at least comparable to or better than the Fama-French three-factor model for the sample periods 1957 to 2005.

Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model

1989

When tastes are represented by a class of generalized preferences which-unlike traditional Von-Neumann preferencesdo not confuse behavior towards risk with attitudes towards intertemporal substitution, the true beta of an asset is, in general, an average of its consumption and market betas. We show that the two parameters measuring risk aversion and intertemporal substitution affect consumption and portfolio allocation decisions in symmetrical ways. A unit elasticity of intertemporal substitution gives rise to myopia in consumption-savings decisions (the future does not affect the optimal consumption plan), while a unit coefficient of relative risk aversion gives rise to myopia in portfolio allocation (the future does not affect optimal portfolio allocation). The empirical evidence is consistent with the behavior of intertemporal maximizers who have a unit coefficient of relative risk aversion and an elasticity of intertemporal substitution different from 1.

Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices

Journal of Political Economy, 2002

We examine how cross-sectional heterogeneity in preferences affects equilibrium behavior of asset prices. We obtain explicit characterization of the competitive equilibrium in an exchange economy in which individual agents have catching up with the Joneses preferences and differ only with respect to the curvature of their utility functions. We show that heterogeneity can have a drastic effect on the behavior of asset prices, in particular, on their conditional moments. Dynamic redistribution of wealth among the agents in heterogeneous economies leads to time-variation in aggregate risk aversion and market price of risk, generating empirically observed negative relation between conditional return volatility and expected returns on one hand and the level of stock prices on the other hand. This stands in contrast with the behavior of homogeneous economies with the same preferences, in which such relation is positive. Quantitatively, the heterogeneous model is capable of replicating various empirical properties of asset prices.

Substitution, Risk Aversion and Asset Prices: An Expected Utility Approach

The standard power utility function is widely used to explain asset prices. It assumes that the coefficient of relative risk aversion is the inverse of the elasticity of substitution. Here I use the Kihlstrom and Mirman (1974) expected utility approach to relax this assumption. I use time consistent preferences that lead to time consistent plans. In our examples, the past does not matter much for current portfolio decisions. The risk aversion parameter can be inferred from experiments and introspections about bets in terms of permanent consumption (wealth). Evidence about the change in the attitude towards bets over the life cycle may also restrict the value of the risk aversion parameter. Monotonic transformations of the standard power utility function do not change the predictions about asset prices by much. Both the elasticity of substitution and risk aversion play a role in determining the equity premium.

Preferences, consumption smoothing, and risk premia

1997

Risk premia in the consumption capital asset pricing model depend on preferences and dividend. We develop a decomposition which allows a separate treatment of both components. We show that preferences alone determine the risk-return tradeoff measured by the Sharpe-ratio. In general, the risk-return trade-off implied by preferences depends on the elasticity of a preference-based stochastic discount factor for pricing assets with respect to the consumption innovation. Depending on the particular specification of preferences, the absolute value of this elasticity can coincide to the inverse of the elasticity of intertemporal substitution (e.g. for habit formation preferences) or the coefficient of relative risk-aversion (e.g. for Epstein-Zin preferences). We demonstrate that preferences based on a small elasticity of intertemporal substitution, such as habit formation, produce small risk premia once agents are allowed to save. Departing from the complete markets framework, we show that uninsurable risk can only increase the Sharpe-ratio and risk premia if dividends are correlated with individual consumption.

1SUBSTITUTION and Risk Aversion: Is Risk Aversion Important for Understanding Asset PRICES?1

2005

The log utility function is widely used to explain asset prices. It assumes that both the elasticity of substitution and relative risk aversion are equal to one. Here I show that much of the same predictions about asset prices can be derived from a time-non-separable expected utility function that assumes an elasticity of substitution close to unity but does not impose restrictions on risk aversion to bets in terms of money. 1 I would like to thank Jeff Campbell and Greg Huffman for useful comments on an earlier draft.

Asset Prices with Heterogeneity in Preferences and Beliefs

Review of Financial Studies, 2014

In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have power utility and differ with respect to both beliefs and their preference parameters for time discount and risk aversion. We solve in closed form for the following quantities: optimal consumption and portfolio policies of individual agents; the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; and, the term structure of interest rates. Our solution allows us to identify the strengths and limitations of the model with heterogeneity in both preferences and beliefs. We find that beliefs about the mean growth rate of the aggregate endowment that are pessimistic on average (across investors) lead to a significant increase in the market price of risk, while heterogeneity in risk aversion increases stock-return volatility. Consequently, the equity risk premium, which is the product of the market price of risk and stock return volatility, is considerably higher in the model where average beliefs are pessimistic and risk aversions are heterogeneous, and this is not accompanied by an increase in either the level or the volatility of the short-term riskless rate. The main limitation of the model is that it is stationary only for a restricted set of parameter values, and for these parameter values one can get a high market price of risk and equity risk premium but not excess stock return volatility.

The Term Structure of Risk Premia with Heterogeneous Recursive Preferences and Beliefs

SSRN Electronic Journal, 2017

I investigate the effect of preference and belief heterogeneity on the term structure of risk premia in a continuous-time time economy with Epstein-Zin-Weil preferences. The slope of the term structure of equity risk premia is driven by heterogeneity in the agents' own prices of risk and the sensitivity of the equity market valuation to the changes in economic conditions. As a result, the slope can switch its sign in response to a significant shock to the aggregate consumption. Significant negative shocks shift the consumption and wealth toward the more "pessimistic" agent i.e. the agent with a higher risk aversion or more pessimistic beliefs. As a result, the equity market valuation changes from being pro-cyclical to counter-cyclical, which inverts the term structure. Thus, the model can generate a switch in the sign of the slope of the term structure of the dividend strip risk premia after the 2008-2009 global financial crisis, a result consistent with recent empirical studies and my own calibration based on a proprietary dataset of dividend swap prices.