Behavioral Models of Dynamic Asset Pricing

Abstract

As mentioned in Chaps. 10-11, extensions of consumption based asset pricing models can be found in the work that employs non-separable utility functions, for example models with habit formation and recursive preferences. The latter can be found in Zin and Epstein (1989, 1991). Recent development in modeling asset pricing is characterized by moving away from the paradigm of the rational expected utility maximizing economic agent by emphasizing behavioral features in the agent’s decision making. Since the beginning of the 1990’s, although still grounded in the consumption based asset pricing tradition, models have been developed that stress the role of habits in economic decision making. These are called habit formation models. Another direction was pursued by Thaler et al. (1997), Benartzki and Thaler, and Barberis et al. (2001) who design models in the tradition of behavioral finance. A firm foundation of those behavioral finance models was given by the prospect theory developed by Kahneman and Tversky (1979). This has led to a further development of asset pricing models that take the precautionary behavior of economic agents and their attitude toward risk taking seriously. This approach can more realistically model economic behavior and is designed to give a better account of the risk-free interest rate, equity premium, and Sharpe ratio.