Working Paper: NBER ID: w4624
Authors: Geert Bekaert; Robert J. Hodrick; David A. Marshall
Abstract: Existing general equilibrium models based on traditional expected utility preferences have been unable to explain the excess return predictability observed in equity markets, bond markets, and foreign exchange markets. In this paper, we abandon the expected-utility hypothesis in favor of preferences that exhibit first-order risk aversion. We incorporate these preferences into a general equilibrium two-country monetary model, solve the model numerically, and compare the quantitative implications of the model to estimates obtained from U.S. and Japanese data for equity, bond and foreign exchange markets. Although increasing the degree of first-order risk aversion substantially increases excess return predictability, the model remains incapable of generating excess return predictability sufficiently large to match the data. We conclude that the observed patterns of excess return predictability are unlikely to be explained purely by time-varying risk premiums generated by highly risk averse agents in a complete markets economy.
Keywords: Asset Pricing; Risk Aversion; Market Predictability
JEL Codes: G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| first-order risk aversion (D11) | fluctuations in expected rates of return (G17) |
| first-order risk aversion (D11) | predictability of excess returns (G17) |
| predictability of excess returns (G17) | variability of risk premiums (G19) |
| first-order risk aversion (D11) | variability in intertemporal marginal rates of substitution (D15) |
| variability in intertemporal marginal rates of substitution (D15) | expected returns (G17) |
| risk aversion (D81) | variability of risk premiums (G19) |
| first-order risk aversion (D11) | observed levels of predictability in the data (C29) |