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

66 Pages Posted: 28 Sep 2001

See all articles by Pietro Veronesi

Pietro Veronesi

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

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Date Written: September 2001

Abstract

This Paper reinterprets standard axioms in choice theory to introduce the concepts of 'belief dependent' utility functions and aversion to 'state-uncertainty'. It shows that this type of preference 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 descretization 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

Suggested Citation

Veronesi, Pietro, Belief-Dependent Utilities, Aversion to State-Uncertainty and Asset Prices (September 2001). Available at SSRN: https://ssrn.com/abstract=285511

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