Time-varying, heterogeneous risk aversion and dynamics of asset prices among boundedly rational agents

Abstract

Besides the heterogeneity of agents’ beliefs, we perceive that, contrary to the constant short-term risk attitude of fundamentalists, the risk attitude for chartists varies over time due to psychological factors such as prospect theory’s reflection effect, which refers to the reversing of risk aversion/risk loving in the case of gains/losses. Thus, this paper assumes that complicated dynamics in recent asset markets are attributed to the significant effects of time-varying and heterogeneous risk attitudes as well as agents’ herd behavior, and generalizes an adaptive beliefs system in order to characterize them. This paper also analyzes the existence of stable steady states of the generalized adaptive beliefs system, providing a new psychological insight into excessive and asymmetric volatility. Given the dynamic system, numerical simulations find that, when the chartists are less risk averse than the fundamentalists and their herding propensity increases, time variation in risk attitudes gives rise to large amplitude changes in proportion to agent groups and expand price fluctuations through chaotic dynamics. Along these lines, this paper highlights that psychological factors serve as decisive source of asymmetry in volatility as well as excess volatility, which are observed in the return data.