Optimists, Pessimists, and the Stock Market: The Role of Preferences and Market (In)Completeness
56 Pages Posted: 18 Nov 2013 Last revised: 1 Oct 2015
Date Written: September 21, 2015
We show that a sizable equity premium is compatible with pronounced risk sharing between an optimistic and a pessimistic Epstein-Zin investor in a long-run risk model featuring jumps in expected consumption growth. Our model generates a positive correlation between return volatility and trading volume, as it is observed in the data. Furthermore, it reproduces the stylized fact of a positive link between disagreement and expected returns, volatilities, and trading volume. We investigate the impact of preferences, fundamental dynamics, and market incompleteness in detail and highlight their respective importance for each of our results.
Keywords: Epstein-Zin utility, heterogeneous beliefs, disagreement, long-run risk, market incompleteness
JEL Classification: D52, D53, G12
Suggested Citation: Suggested Citation