‘First-order’ risk aversion and the equity premium puzzle

Epstein, Larry G.; Zin, Stanley E.

doi:10.1016/0304-3932(90)90004-n

Cited by 245 publications

(109 citation statements)

References 22 publications

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“…The intuition behind this approach is that given the risk free rate is mainly controlled by the magnitude of the elasticity of intertemporal substitution, while the risk premium is a reflection of the coefficient of relative risk aversion, a preference ordering that can parametrize the elasticity of intertemporal substitution and the coefficient of relative risk aversion independently should provide the additional degree of freedom required to replicate both the level of the risk free rate and the risk premium. The results reported in Epstein and Zin (1990) and Weil (1989), however, were not very encouraging (although Epstein and Melino (1995) do much better). A second approach modifies the preferences by introducing habit formation.…”

Section: Equity Premium Puzzlementioning

confidence: 85%

State-dependent preferences can explain the equity premium puzzle

Melino

Yang²

2003

Review of Economic Dynamics

112

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We introduce state dependent recursive preferences into the Mehra-Prescott economy. We show that such preferences can match the historical first two moments of the returns on equity and the risk free rate. Other authors have reported similar results using state dependent expected utility preferences. These authors have tended to emphasize the importance of countercyclical risk aversion in explaining the equity premium puzzle. We find that countercyclical risk aversion plays an important role but only when combined with modest cyclical variation in intertemporal substitution. * The first author gratefully acknowledges the research support of SSHRC. We would like to thank Larry Epstein, Miquel Faig, Stephen Gordon, Pascal St-Amour, Jessica Wachter, Xiaodong Zhu, an anonymous referee, and seminar participants at BU, Harvard, Toronto, and NYU for their helpful comments.

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Section: Equity Premium Puzzlementioning

confidence: 85%

State-dependent preferences can explain the equity premium puzzle

Melino

Yang²

2003

Review of Economic Dynamics

112

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“…Maintaining assumptions on recursivity and time-stationarity of intertemporal preferences while incorporating behavioral concepts is both feasible, as shown in Epstein and Zin (1990), and desirable given the discipline that this will naturally enforce on the modeling exercise.…”

Section: Discussionmentioning

confidence: 99%

“…That is, there is a renewed interest in the ability of a tightly parameterized, representative-agent, generalequilibrium model to explain the salient features of historical asset-market data, (e.g., large equity premium, excess volatility, etc.). Researchers in this area have explored a wide variety of models that adopt preference assumption motivated by behavioral evidence such as habit formation (Abel (1990), Constantinides (1990) and Campbell and Cochrane (1995)) loss aversion (Epstein and Zin (1990), Benartzi and Thaler (1995), and Barberis, Huang and Santos (1999)), and hyperbolic discounting (Luttmer and Mariotti (2000) and Krussell and Smith (2000)), to list a few prominent examples. Indeed as more experimental evidence filters into economics from various fields of psychology, this list continues to grow.…”

Section: Introductionmentioning

confidence: 99%

Are behavioral asset-pricing models structural?

Zin

2002

Journal of Monetary Economics

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The recent increase in interest in so-called behavioral models of asset-pricing is motivated partly by the desire to have models that appear realistic in light of experimental evidence, and partly by their success in moment-matching exercises. This paper argues that the attention given to these two criteria misses perhaps the most important aspect of the modeling exercise. That is, the search for parameters that are invariant to changes in the economic environment. It is precisely this invariance that motivates the use of a tightly parameterized general equilibrium model. Assessing a model on this dimension is difficult and, as the paper argues through the use of suggestive examples, will undoubtedly require strong subjective judgments about the reasonableness of preference assumptions. Such judgments are routinely made about the reasonableness of assumptions about stochastic endowments. The paper suggests that more effort be applied to understanding aggregation in these models and to the exploration of behavioral assumptions in a less flexible but less corruptible time-stationary recursive class of preferences. To put the point less paradoxically, the relevant question to ask about the "assumptions" of a theory is not whether they are descriptively "realistic," for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions. (Milton Friedman, 1953) On this general view of the nature of economic theory then, a "theory" is not a collections of assertions about the behavior of the actual economy but rather an explicit set of instructions for building a parallel or analogue system-a mechanical, imitation economy. A "good" model, from this point of view, will not be exactly more "real" than a poor one, but will provide better imitations. Of course, what one means by a "better imitations" will depend on the particular questions to which one wishes answers. (Robert E. Lucas, Jr., 1980)

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“…We start by studying the optimal asset allocation behavior of a linear loss-averse investor. This 3 This is also referred to as the first-order risk aversion (see Epstein and Zin, 1990). …”

Section: Portfolio Optimization Under Linear Loss Aversionmentioning

confidence: 99%

Optimal asset allocation under linear loss aversion

Fortin

Hlouskova

2011

Journal of Banking & Finance

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Growing experimental evidence suggests that loss aversion plays an important role in asset allocation decisions. We study the asset allocation of a linear loss-averse (LA) investor and compare the optimal LA portfolio to the more traditional optimal mean-variance (MV) and conditional value-at-risk (CVaR) portfolios. First we derive conditions under which the LA problem is equivalent to the MV and CVaR problems. Then we analytically solve the twoasset problem, where one asset is risk-free, assuming binomial or normal asset returns. In addition we run simulation experiments to study LA investment under more realistic assumptions. In particular, we investigate the impact of different dependence structures, which can be of symmetric (Gaussian copula) or asymmetric (Clayton copula) type. Finally, using 13 EU and US assets, we implement the trading strategy of an LA investor assuming assets are reallocated on a monthly basis and find that LA portfolios clearly outperform MV and CVaR portfolios.

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‘First-order’ risk aversion and the equity premium puzzle

Cited by 245 publications

References 22 publications

State-dependent preferences can explain the equity premium puzzle

State-dependent preferences can explain the equity premium puzzle

Are behavioral asset-pricing models structural?

Optimal asset allocation under linear loss aversion

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