Abstract
This paper presents a simple rational expectations model of intertemporal asset pricing relating instability of stock return characteristics to heterogeneity in investor preferences. Heterogeneity is likely to generate declining aggregate relative risk aversion. This leads to variability in expected asset returns, volatility, and autocorrelation. The stronger this variability is, the more heterogeneous preferences are, implying more instability of financial markets. Stock market crashes may be observed if relative risk aversion differs strongly across investors.
Highlights
The last twenty five years witnessed various sudden shifts in valuation so that instability of financial markets does not seem to be the exception but the rule
In a simple intertemporal equilibrium model we show that heterogeneous investor preferences are likely to cause declining aggregate relative risk aversion
Financial instability is largely driven by the pattern of aggregate RRA
Summary
The last twenty five years witnessed various sudden shifts in valuation so that instability of financial markets does not seem to be the exception but the rule. Financial instability is measured by the variability in characteristics of stock return processes, in particular, expected return, volatility, and autocorrelation. The more these characteristics vary, the stronger is instability. Our model delivers rather stable time series characteristics of stock returns given smoothly declining aggregate relative risk aversion, but unstable characteristics given strong variations in the decline of relative risk aversion. In the latter case, the model indicates strong variability in expected stock returns, volatility, and in serial correlation of stock returns. It even explains crashes without significant fundamental news for which
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