Asset Prices with Heterogeneous Loss Averse Investors
44 Pages Posted: 21 Jun 2012 Last revised: 1 Nov 2012
Date Written: October 30, 2012
This paper considers a general-equilibrium model with loss-aversion in consumption and heterogeneity: there is a continuum of agents, with s-shaped utility, who differ in the time-varying reference level of consumption. Heterogeneity in the reference level is crucial for the existence of the equilibrium, which cannot be obtained with a representative agent or a discrete number of agents. Loss-aversion in consumption induces a kink in the pricing kernel and consequently, jumps in the market price of risk, stock return, and volatility. An economy populated with only loss-averse agents produces one counter-factual property of asset price: the return volatility and the market price of risk are higher in good times than in bad times. The coexistence of both loss-averse and risk-averse agents in the economy helps fixing this undesirable property and also explains the dynamics of trading volume and its correlation with asset prices.
Keywords: equilibrium, heterogeneity, loss aversion, local time, trading volume
JEL Classification: G11, G12
Suggested Citation: Suggested Citation