Working Paper: NBER ID: w8607
Authors: Yeung Lewis Chan; Leonid Kogan
Abstract: We analyze a general equilibrium exchange economy with a continuum of agents who have 'catching up with the Joneses' preferences and differ only with respect to the curvature of their utility functions. While individual risk aversion does not change over time, dynamic redistribution of wealth among the agents leads to countercyclical time variation in the Sharpe ratio of stock returns. We show that both the conditional risk premium and the return volatility are negatively related to the level of stock prices, as observed empirically. Therefore, our model exhibits many of the empirically observed properties of aggregate stock returns, e.g., patterns of autocorrelation in returns, the 'leverage effect' in return volatility and long-horizon return predictability. For comparison, otherwise similar representative agent economies with the same type of preferences exhibit counter-factual behavior, e.g., a constant Sharpe ratio of returns and procyclical risk premium and return volatility.
Keywords: No keywords provided
JEL Codes: G12; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock price movements (G12) | risk premium (G19) |
| stock prices decline (G10) | aggregate risk aversion increases (D11) |
| wealth distribution among agents (D39) | stock returns (G12) |
| stock prices (G12) | return volatility (G17) |
| conditional risk premium (D81) | stock prices (G12) |