Expectations-Based Reference-Dependent Preferences and Asset Pricing

50 Pages Posted: 22 May 2013

See all articles by Michaela Pagel

Michaela Pagel

Columbia University - Columbia Business School

Date Written: December 28, 2012

Abstract

This paper incorporates expectations-based reference-dependent preferences into the canonical Lucas-tree asset-pricing economy. Expectations-based loss aversion increases the equity premium and decreases the consumption-wealth ratio, because uncertain fluctuations in consumption are more painful. Moreover, because unexpected cuts in consumption are particularly painful, the agent wants to postpone such cuts to let his reference point decrease. Thus, even though shocks are i.i.d., loss aversion induces variation in the consumption-wealth ratio, which generates variation in the equity premium, expected returns, and predictability. The level and variation in the equity premium and the predictability in returns match historical moments, but the associated variation in intertemporal substitution motives results in excessive variation in the risk-free rate. This effect can be partially offset with variation in expected consumption growth, heteroskedasticity in consumption growth, or time-variant disaster risk. As a key contribution, I show that the preferences resolve the equity-premium puzzle and simultaneously imply plausible risk attitudes towards small and large wealth bets.

Keywords: Expectations-based reference-dependent preferences, asset pricing, equity premium puzzle, predictability

JEL Classification: G02, G12, D03

Suggested Citation

Pagel, Michaela, Expectations-Based Reference-Dependent Preferences and Asset Pricing (December 28, 2012). Available at SSRN: https://ssrn.com/abstract=2268256 or http://dx.doi.org/10.2139/ssrn.2268256

Michaela Pagel (Contact Author)

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
96
Abstract Views
569
rank
299,444
PlumX Metrics