Higher-Moment Asset Pricing and Allocation in a Heterogeneous Market Equilibrium

Abstract

Investors have different preferences for portfolio skewness and kurtosis, i.e. return asymmetry and tail fatness. We build up a new equilibrium model with three types of investors whose preferences can be characterized by "MV", "MVS" and "MVSK". (M: Mean V: Variance S: Skewness K: Kurtosis) and they are named as "Traditional", "Lotto" and "Kurtosis Aversion" investor, correspondingly. We study how the heterogeneous preferences can impact equilibrium asset return and optimal allocation. In addition, we investigate how the change of investor proportion on the market influences the equilibrium properties. Furthermore, by using the weekly world stock market indices (MSCI) ranging from January 1988 till January 2010, we are able to recover the investor composition in the bullish and bearish markets. We find that during Dotcom crash and Subprime crisis, there are more Traditional and Lotto investors than Kurtosis Aversion investors existing on the market; during Dotcom boom, Traditional and Kurtosis Aversion investors are the majority; in Housing boom, most of the investors are the Lotto investors. To our best knowledge, we are the first to investigate this problem in a partial equilibrium setting and the model prediction is supported by the empirical evidence.

Keywords: higher moment preference, asset pricing, portfolio allocation, equilibrium

JEL Classification: G11, G12, G15, P36