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Preferences with Taste Shock Representations: Price Volatility and the Liquidity Premium

13 Pages Posted: 11 Jun 2016  

R. Vijay Krishna

Florida State University - Department of Economics

Philipp Sadowski

Duke University - Department of Economics

Date Written: June 9, 2016

Abstract

If price volatility is caused in some part by taste shocks, then it should be positively correlated with the liquidity premium. Our argument is based on Krishna and Sadowski (2014), who provide foundations for a representation of dynamic choice with taste shocks, and show that volatility in tastes corresponds to a desire to maintain flexibility. To formally connect volatile tastes to price volatility and preference for flexibility to the liquidity premium, we analyze a modified simple Lucas tree economy, where the representative agent is uncertain about his degree of future risk aversion, and where the productive asset cannot be traded in every period, while rights to output can. We show that a representative agent with a higher degree of uncertainty about his future risk aversion implies a higher liquidity premium (i.e., a lower price for the illiquid asset) and more price volatility.

Suggested Citation

Krishna, R. Vijay and Sadowski, Philipp, Preferences with Taste Shock Representations: Price Volatility and the Liquidity Premium (June 9, 2016). Economic Research Initiatives at Duke (ERID) Working Paper No. 219. Available at SSRN: https://ssrn.com/abstract=2793447 or http://dx.doi.org/10.2139/ssrn.2793447

R. Vijay Krishna

Florida State University - Department of Economics ( email )

Tallahassee, FL 30306-2180
United States

Philipp Sadowski (Contact Author)

Duke University - Department of Economics ( email )

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States
919-660-1800 (Phone)

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