Asset Prices and Portfolio Choice with Heterogeneous Risk Aversion and Overlapping Generations

Abstract

With overlapping generations and heterogeneous risk aversion there is no unique relation between aggregate risk aversion and the real rate of interest, and this type of endogenous “noise” cannot arise in an economy where agents live forever. Our framework accommodates many agent types and the noise emerges precisely because all (but one) consumption shares drive the economy. Adding wealth dispersion to aggregate risk aversion sufficiently summarizes the rich dynamics of the model. Consistent with the model, we construct “level” and “slope” factors that do not require knowledge about agents’ risk aversion to predict excess returns.