The Long Horizon Behavior of Asset Prices in Heterogeneous Economies

Abstract

We give a complete description of long horizon behavior of asset returns in economies populated by heterogeneous agents with arbitrary discount factors and risk aversions. We find that for every type of asset there is a corresponding dominant agent who determines the long run rate of return on the asset. For example, there is a (generically) unique agent who eventually consumes everything at infinite horizon and determines the long run short term interest rate. There is another agent who determines the expected return rate on holding equity forever. There is a third agent who determines the very long end of the interest rate term structure. It is shown that a large equity premium will result if the preferences of these dominant agents are sufficiently different. The interplay between these dominant agents generates countercyclical dynamics of equity premium and conditional variance of equity returns as well as procyclical dynamics of price-dividend ratios. We obtain sharp bounds (from above and below) for the yield curve, giving a complete answer to a question posed by Dumas (1989). Surprisingly, we find that discount factors and risk aversions of the dominant agents are positively correlated, in line with existing social experiments.