Abstract
We study experimentally how subjects react to changes in interest rates. Our participants were asked to divide 1,000 units of currency between two assets – one risky and the other risk-free – in four different settings. We use different treatments to change the risk-free rate while keeping the risk premium constant. We find that risk-free rates affect risk allocation asymmetrically: subjects increase the risky portion in their portfolios in response to a decrease in rates. Still, they do not change their portfolios when rates rise. Furthermore, this asymmetric effect occurs only when interest rates remain constant over a relatively long duration; when they are volatile, their impact on risk allocation is reversed. We provide and test a behavioral explanation for these findings.
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