Evidence for Countercyclical Risk Aversion: An Experiment with Financial Professionals

American Economic Review, Forthcoming

UBS Center Working Paper Series Working Paper No. 4

33 Pages Posted: 19 Sep 2013 Last revised: 25 Sep 2014

See all articles by Alain Cohn

Alain Cohn

University of Michigan

Jan Engelmann

University of Zurich - Faculty of Economics, Business Administration and Information Technology

Ernst Fehr

University of Zurich - Department of Economics

Michel André Maréchal

University of Zurich - Department of Economics

Date Written: August 1, 2014

Abstract

A key ingredient of many popular asset pricing models is that investors exhibit countercyclical risk aversion, which helps explain major economic puzzles such as the strong and systematic variation in risk premiums over time and the high volatility of asset prices. There is, however, surprisingly little evidence for this assumption because it is difficult to control for the host of factors that change simultaneously during financial booms and busts. We circumvent these control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes. Subjects who were primed with a financial bust were substantially more risk averse than those who were primed with a boom. Subjects were also more fearful in the bust than in the boom condition, and their fear is negatively related to investments in the risky asset, suggesting that fear may play an important role in countercyclical risk aversion. The mechanism described in this paper is relevant for theory and has important implications, as it provides the basis for a self-reinforcing process that amplifies market dynamics.

Keywords: Countercyclical Risk Aversion, Experiment, Financial Professionals

JEL Classification: G02, C91

Suggested Citation

Cohn, Alain and Engelmann, Jan and Fehr, Ernst and Maréchal, Michel André, Evidence for Countercyclical Risk Aversion: An Experiment with Financial Professionals (August 1, 2014). American Economic Review, Forthcoming, UBS Center Working Paper Series Working Paper No. 4, Available at SSRN: https://ssrn.com/abstract=2327557 or http://dx.doi.org/10.2139/ssrn.2327557

Alain Cohn (Contact Author)

University of Michigan ( email )

105 S State St
Ann Arbor, MI 48109
United States

Jan Engelmann

University of Zurich - Faculty of Economics, Business Administration and Information Technology ( email )

Zurich, 8006
Switzerland

Ernst Fehr

University of Zurich - Department of Economics ( email )

Blümlisalpstrasse 10
Zuerich, 8006
Switzerland
+41 1 634 3709 (Phone)
+41 1 634 4907 (Fax)

Michel André Maréchal

University of Zurich - Department of Economics ( email )

Zuerich, 8006
Switzerland

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