Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies

36 Pages Posted: 17 Nov 2001 Last revised: 25 Oct 2010

See all articles by Leonid Kogan

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: November 2001

Abstract

In this article, we show how to analyze analytically the equilibrium policies and prices in an economy with a stochastic investment opportunity set and incomplete financial markets, when agents have power utility over both intermediate consumption and terminal wealth, and face portfolio constraints. The exact local comparative statics and approximate but analytical expression for the portfolio policy and asset prices are obtained by developing a method based on perturbation analysis to expand around the solution for an investor with log utility. We then use this method to study a general equilibrium exchange economy with multiple agents who differ in their degree of risk aversion and face borrowing constraints. We characterize explicitly the consumption and portfolio policies and also the properties of asset returns. We find that the volatility of stock returns increases with the cross-sectional dispersion of risk aversion, with the cross-sectional dispersion in portfolio holdings, and with the relaxation of the constraint on borrowing. Moreover, tightening the borrowing constraint lowers the risk-free interest rate and raises the equity premium in equilibrium.

Suggested Citation

Kogan, Leonid and Uppal, Raman, Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies (November 2001). NBER Working Paper No. w8609. Available at SSRN: https://ssrn.com/abstract=291284

Leonid Kogan (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER)

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Raman Uppal

EDHEC Business School ( email )

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Centre for Economic Policy Research (CEPR)

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