Preference Heterogeneity and Asset Prices: An Exact Solution

29 Pages Posted: 24 Nov 2009 Last revised: 6 Apr 2010

Date Written: February 11, 2010

Abstract

We introduce a general equilibrium model of a multi-agent, pure-exchange economy and find a set of conditions that enable us to obtain explicit closed form solutions to the equilibrium interest rate, stock price, risk premium and stock market volatility when investors have heterogeneous risk aversions. Because the market is dynamically complete, full risk sharing obtains and a representative agent can be constructed, though the risk aversion of this agent fluctuates over time with the state of the economy, as the relative wealth distribution of the individual investors changes. We show that preference heterogeneity can cause asset prices to be significantly more volatile than the underlying dividends and that it can lead to leverage-like effects in volatility, in the sense that volatility increases after stock-market declines.

Suggested Citation

Weinbaum, David, Preference Heterogeneity and Asset Prices: An Exact Solution (February 11, 2010). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1508925

David Weinbaum (Contact Author)

Syracuse University ( email )

Syracuse, NY
United States

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