Preferences Heterogeneity in Asset Pricing Models: Inspecting the Mechanism

Abstract

This study examines the economic forces behind the effects of risk-averse heterogeneity on quantities and asset prices. We show that the consumption distribution, generated by preference heterogeneity, is crucial in determining the interest rate, Sharpe ratio, and volatility of the agent's consumption and wealth. However, wealth distribution plays a key role in explaining optimal portfolios, stock price volatility, and credit size in the economy. Our analysis demonstrates that the risk-averse dispersion between agents has first-order consequences on equilibrium and welfare dispersion. Therefore, the level and dispersion of preference heterogeneity matter for asset prices.

Keywords: heterogeneous agents, Risk aversion, Asset pricing, finite difference.