Belief-Dependent Utilities, Aversion to State-Uncertainty and Asset Prices

Abstract

This paper reinterprets standard axioms in choice theory to introduce the concepts of "belief dependent" utility functions and aversion to "state-uncertainty," and it shows that this type of preferences helps to explain the various stylized facts of asset returns, including a high equity risk premium, a low risk-free rate, a high return volatility, stock return predictability and volatility clustering. In one particular specification consistent with habit formation preferences, I also argue that "aversion to state uncertainty" gives rise to "aversion to long run risk," that is, to the uncertainty surrounding the long run average of future consumption. In order to solve for asset prices and returns under general conditions about the hidden state variable, the paper also develops a discretization methodology to obtain approximate analytical solutions. In a parsimonious parametrization, I then show that the model calibrated to real consumption generates unconditional moments for asset returns that closely match the empirical ones. Finally, due to the estimated time-variation in the dispersion of the conditional distribution on the drift rate of consumption, the model also generates a time series of conditional return volatility in line with the ex-post integrated volatility of stock returns.

Keywords: State-dependent Preferences, Uncertainty Aversion, Asset Pricing

JEL Classification: D81, G12