Asset Returns and State-Dependent Risk Preferences
CIRPEE Working Paper No. 03-16
33 Pages Posted: 20 May 2003
Date Written: March 2003
We propose a consumption-based capital asset pricing model in which the representative agent's preferences display state-dependent risk aversion. We obtain a valuation equation in which the vector of excess returns on equity includes both consumption risk as well as the risk associated with variations in preferences. We develop a simple model that can be estimated without specifying the functional form linking risk aversion with state variables. Our estimates are based on Markov chain Monte Carlo estimation of exact discrete-time parameterizations for linear diffusion processes. Since consumption risk is not forced to account for the entire risk premium, our results contrast sharply with estimates from models in which risk aversion is state-independent. We find that relaxing fixed risk preferences yields estimates for relative risk aversion that are (i) reasonable by usual standards, (ii) correlated with both consumption and returns and (iii) indicative of an additional preference risk of holding the assets.
Keywords: Asset pricing models, Bayesian analysis, continuous-time econometric models, data augmentation, equity premium puzzle, Markov chain Monte Carlo, risk aversion, state-dependent preferences, wealth
JEL Classification: C110, D810, G120
Suggested Citation: Suggested Citation