The Implications of First-Order Risk Aversion for Asset Market Risk Premiums

Posted: 15 Sep 1999

See all articles by Geert Bekaert

Geert Bekaert

Columbia Business School - Finance and Economics

Robert J. Hodrick

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

David A. Marshall

Federal Reserve Bank of Chicago; University of Chicago - Booth School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: January 1994

Abstract

In this paper, we ask whether high levels of risk aversion can explain the observed predictability of excess returns within the context of a frictionless, representative agent model. In order to give this explanation the best chance for success, we assume that agents' preferences display first-order risk aversion. This preference specification implies that agents respond more strongly to consumption risk than would be the case under conventional Von Neuman- Morgenstern preferences. Yet, even this more extreme form of risk aversion can explain only a small fraction of the predictability of excess returns found in the data. Furthermore, we find that the slope coefficients in equations predicting excess returns do not increase monotonically with increased risk aversion. The level of risk aversion affects not only the variability of risk premiums, but also the second moments of other endogenous variables which affect predictability. The resulting implications for the signs and magnitudes of these slope coefficients are ambiguous. Taken together, the results of this paper suggest that the predictability of excess returns cannot be fully explained simply by modifying preference assumptions. A more promising approach may be to abandon the assumption that the empirical distribution in the data set is a good proxy for agents' subjective distribution over future variables. Rational optimizing models that do not impose this assumption include learning models, models with peso- problems, and some models with regime switching. It is hoped that these alternative approaches will have more success in explaining excess-return predictability than approaches based solely on modeling agents' aversion to consumption risk.

JEL Classification: G10

Suggested Citation

Bekaert, Geert and Hodrick, Robert J. and Marshall, David Aaron, The Implications of First-Order Risk Aversion for Asset Market Risk Premiums (January 1994). Available at SSRN: https://ssrn.com/abstract=5868

Geert Bekaert

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Robert J. Hodrick (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

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New York, NY 10016-4309
United States

David Aaron Marshall

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604-1413
United States
312-322-5111 (Phone)

University of Chicago - Booth School of Business ( email )

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Chicago, IL 60637
United States

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