Investor Heterogeneity, Asset Pricing and Volatility Dynamics

34 Pages Posted: 24 Dec 2008 Last revised: 14 Apr 2009

Date Written: December 23, 2008

Abstract

We provide an explicit characterization of the equilibrium when investors have heterogeneous risk preferences. Given market completeness, investors can achieve full risk sharing. Thus a representative agent can be constructed, though this agent's risk aversion changes over time as the relative wealths of the individual investors change. We show that volatility depends on the covariance of aggregate risk aversion and stock returns. We find that heterogeneity increases volatility, produces volatility clustering (ARCH effects) and "leverage"-like effects. Option prices exhibit implied volatility skews. There is predictability and we assess the magnitude of investors' hedging demands and trading volume. Further, diversity is beneficial to all agents and entails welfare gains that can be substantial.

Keywords: Preference heterogeneity, volatility, general equilibrium

JEL Classification: G12

Suggested Citation

Weinbaum, David, Investor Heterogeneity, Asset Pricing and Volatility Dynamics (December 23, 2008). Journal of Economic Dynamics and Control, Forthcoming, Johnson School Research Paper Series No. #13-09, Available at SSRN: https://ssrn.com/abstract=1319943

David Weinbaum (Contact Author)

Syracuse University ( email )

Syracuse, NY
United States

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