Working Paper: CEPR ID: DP2965
Authors: Pietro Veronesi
Abstract: This Paper reinterprets standard axioms in choice theory to introduce the concepts of ?belief dependent? utility functions and aversion to ?state-uncertainty?. It shows that this type of preference helps to explain the various stylized facts of asset returns, including a high equity risk premium, a low risk-free rate, a high return volatility, stock return predictability and volatility clustering. In one particular specification consistent with habit formation preferences, I also argue that ?aversion to state-uncertainty? gives rise to ?aversion to long-run risk?, that is, to the uncertainty surrounding the long-run average of future consumption. In order to solve for asset prices and returns under general conditions about the hidden state variable, the Paper also develops a discretization methodology to obtain approximate analytical solutions. In a parsimonious parametrization, I then show that the model calibrated to real consumption generates unconditional moments for asset returns that closely match the empirical ones. Finally, due to the estimated time-variation in the dispersion of the conditional distribution on the drift rate of consumption, the model also generates a time series of conditional return volatility in line with the ex-post integrated volatility of stock returns.
Keywords: Asset Pricing; State-Dependent Preferences; Uncertainty Aversion
JEL Codes: D81; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| belief-dependent utilities (D81) | asset prices (G19) |
| aversion to state uncertainty (D81) | low risk-free rate (G19) |
| belief-dependent utilities (D81) | risk perceptions (D81) |
| risk perceptions (D81) | demand for risk-free assets (E41) |
| time-varying dispersion of consumption drift rates (C22) | high return volatility (G17) |