Heterogeneous Risk Aversion Research Articles

Evolutionary foundation for heterogeneity in risk aversion

We examine the evolutionary basis for risk aversion with respect to aggregate risk. We study populations in which agents face choices between alternatives with different levels of aggregate risk. We show that the choices that maximize the long-run growth rate are induced by a heterogeneous population in which the least and most risk-averse agents are indifferent between facing an aggregate risk and obtaining its linear and harmonic mean for sure, respectively. Moreover, approximately optimal behavior can be induced by a simple distribution according to which all agents have constant relative risk aversion, and the coefficient of relative risk aversion is uniformly distributed between zero and two.

Does Heterogeneity in Risk Aversion Imply a Downward-Sloping Equity Term Structure?

Does Heterogeneity in Risk Aversion Imply a Downward-Sloping Equity Term Structure?

Modeling traveler’s speed-route joint choice behavior with heterogeneous safety concern

In this study, a speed-route joint choice model considering traveler’s safety concerns is proposed to concurrently model traveler’s safety-oriented travel speed and route choice behavior. Specifically, the safe-speed choice behavior is modeled as a trade-off process between perceived traffic safety and efficiency using a disutility function. The safe-route choice behavior is described by the proposed Mean-excess Crash Risk Cost model, where the route safety is modeled as a random variable following a specific distribution, and traveler’s concerns about both reliability and unreliability aspects of safety variability are considered. The model is accommodative to account for the random nature and the traveler’s perception of traffic safety. Also, the travel time cost is considered, which is depicted as a parallel criterion of travel safety in the route choice model. Moreover, the heterogeneities of travelers’ safety concerns in both the choices of speed and route are considered in the proposed joint model. Then, the study formulated the equilibrium problem with the two behavior elements (speed and route) and two choice criteria (safety and time), based on the assumption that all travelers tend to maximize their disutility when choosing speed while minimizing their travel safety variability and travel time. To illustrate the model, Nguyen and Dupuis, Sioux falls, and Changsha arterial networks are conducted as numerical studies. The result demonstrates the model’s capability in depicting travelers’ trade-off between safety and time when selecting the optimal travel speed. Considering the impact of route safety unreliability makes the model sensible to describe travelers’ safety-concerned route choice behavior. The model is also flexible to account for travelers’ crash risk aversion heterogeneity.

Paying for beta: Leverage demand and asset management fees

We examine how investor demand for leverage shapes asset management fees. We show that in the sample of U.S. equity mutual funds: (1) fees increase in fund market beta precisely for beta larger than one; (2) this relation becomes stronger and high-beta funds experience larger inflows when leverage constraints tighten; and (3) low net alphas are especially common among high-beta funds. These results are consistent with a model in which asset managers compete for leverage-constrained investors with heterogeneous risk aversion. The asymmetric relation between betas and fees also extends to the HML and SMB factors.

The Cross-Section of Household Preferences

This paper estimates the cross-sectional distribution of Epstein-Zin preference parameters in a large administrative panel of Swedish households. We consider life-cycle model of saving and portfolio choice that incorporates risky labor income, safe and risky financial assets inside and outside retirement accounts, and real estate. We study middle-aged stock-owning households grouped by education, industry of employment, and birth cohort as well as by their accumulated wealth and risky portfolio shares. We find some heterogeneity in risk aversion (a standard deviation of 0.47 around a mean of 5.24 and median of 5.30) and considerable heterogeneity in the time preference rate (standard deviation 6.0% around a mean of 6.2% and median of 4.1%) and elasticity of intertemporal substitution (standard deviation 0.96 around a mean of 0.99 and median of 0.42). Risk aversion and the EIS are almost cross-sectionally uncorrelated, in contrast with the strong negative correlation that we would find if households had power utility with heterogeneous risk aversion. The TPR is weakly negatively correlated with both the other parameters. We estimate lower risk aversion for households with riskier labor income and higher levels of education, and a higher TPR and lower EIS for households who enter our sample with low initial wealth.

Adverse selection in Australian private health insurance

We assess adverse selection in Australian private health insurance using the longitudinal data in the Household, Income, and Labour Dynamics in Australia (HILDA) Survey. Cross-sectional and balanced panel probit regressions specify the demand for health insurance as a function of selfassessed health condition, health risk factors, and socioeconomic controls including age, income, education, family structure, and welfare status. We find that while adverse selection is present, it has decreased over time, likely through a combination of deliberate government policy and changes in market conditions, combined with the impact of heterogeneous preferences and risk aversion. We also identify a tendency for advantageous selection in the insured pool.

Improving on Defaults: Helping Pension Participants Manage Financial Market Risk in Target Date Funds

The central issue of this paper is analysis and resulting proposals to help unsophisticated pension participants achieve pension portfolios that match their level of risk aversion when there is a large amount of unexplained heterogeneity in risk aversion. Target date funds are commonly used as the default investment in defined contribution plans in the U.S., UK and other countries. These funds recognize that individuals usually should hold less risky investment portfolios as their expected retirement date approaches because their ability to bear financial market risk declines as the time horizon decreases. However, these funds do not account for differences in risk aversion among people with the same target date. Empirical studies find large amounts of unexplained heterogeneity in risk aversion. Target date funds cannot deal with this issue simply by sorting people into demographic groupings, other than age, that are known to affect risk aversion, such as gender. Financial education can help people do a better job of managing financial market risk in their pension portfolios, but we argue that it is unreasonable to expect millions of pension participants to attain advanced levels of financial literacy. This paper considers three innovations in target date funds that can help individual pension participants do a better job of managing financial market risk. The analysis can be applied to other situations where defaults are used for investing pension participants’ portfolios. The paper suggests new lines of research relating to individual differences in risk aversion.

Heterogeneous preferences, investment, and asset pricing

AbstractWe present a production‐based model in which agents have heterogeneous risk aversion and heterogeneous discount rate. Compared to the exchange economy, the aggregate consumption‐capital ratio and aggregate consumption volatility is reduced. The risk premium and the volatility of stock return increase when moving from the exchange economy to the production economy. We also find that the volatility of Tobin's q exhibits an inverted‐U‐shape and Tobin's q is procyclical.

Asset Prices and Portfolio Choice with Heterogeneous Risk Aversion and Overlapping Generations

With overlapping generations and heterogeneous risk aversion there is no unique relation between aggregate risk aversion and the real rate of interest, and this type of endogenous “noise” cannot arise in an economy where agents live forever. Our framework accommodates many agent types and the noise emerges precisely because all (but one) consumption shares drive the economy. Adding wealth dispersion to aggregate risk aversion sufficiently summarizes the rich dynamics of the model. Consistent with the model, we construct “level” and “slope” factors that do not require knowledge about agents’ risk aversion to predict excess returns.

The Cross-Section of Household Preferences

This paper estimates the cross-sectional distribution of Epstein-Zin preference parameters in a large administrative panel of Swedish households. We consider life-cycle model of saving and portfolio choice that incorporates risky labor income, safe and risky financial assets inside and outside retirement accounts, and real estate. We study middle-aged stock-owning households grouped by education, industry of employment, and birth cohort as well as by their accumulated wealth and risky portfolio shares. We find some heterogeneity in risk aversion (a standard deviation of 0.47 around a mean of 5.24 and median of 5.30) and considerable heterogeneity in the time preference rate (standard deviation 6.0% around a mean of 6.2% and median of 4.1%) and elasticity of intertemporal substitution (standard deviation 0.96 around a mean of 0.99 and median of 0.42). Risk aversion and the EIS are almost cross-sectionally uncorrelated, in contrast with the strong negative correlation that we would find if households had power utility with heterogeneous risk aversion. The TPR is weakly negatively correlated with both the other parameters. We estimate lower risk aversion for households with riskier labor income and higher levels of education, and a higher TPR and lower EIS for households who enter our sample with low initial wealth. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Evolutionary Foundation for Heterogeneity in Risk Aversion

We examine evolutionary basis for risk aversion with respect to aggregate risk. We study populations in which agents face choices between aggregate risk and idiosyncratic risk. We show that the choices that maximize the long-run growth rate are induced by a heterogeneous population in which the least and most risk averse agents are indifferent between aggregate risk and obtaining its linear and harmonic mean for sure, respectively. Moreover, an approximately optimal behavior can be induced by a simple distribution according to which all agents have constant relative risk aversion, and the coefficient of relative risk aversion is uniformly distributed between zero and two.

The Macroeconomic Uncertainty Premium in the Corporate Bond Market

AbstractWe examine the role of macroeconomic uncertainty in the cross section of corporate bonds and find a significant uncertainty premium for both investment-grade (IG) (0.40% per month) and non-investment-grade (NIG) (0.81% per month) bonds. The economic-uncertainty premium declines as we progressively remove downgraded bonds, indicating that the premium represents an increase in required returns for bonds with higher credit and macroeconomic risk. The economic-uncertainty premia vary across equities and bonds in a manner consistent with the heterogeneous risk-aversion levels of dominant players in equities (retail investors) versus bonds (institutional investors).

SOVEREIGN DEFAULT CONTAGION AND MONETARY POLICY IN AN AGENT-BASED MODEL

Sovereign default contagion was one of the most debated topics during the Eurozone sovereign debt crisis. Despite all the improvements in the financial situation since 2010, namely after European Central Bank quantitative easing policies, the nature of the problem and the policy prescriptions are still under dispute today. Using an agent-based model, we simulate sovereign default contagion for different monetary policy options in a world where governments have random incomes, different heterogeneous borrowing behaviors and risk aversion levels and where countries can enter into ex-ante agreements to protect themselves against default. Our simulations showed that default contagion can be a very fast and “destructive” process, and that monetary policy can have a very important role in preventing sovereign defaults through zero interest rate and quantitative easing policies.

Heterogeneous risk preferences in community-based electricity markets

Organization in electricity markets is evolving from centralized pool-based to decentralized peer-to-peer structures. Within this decentralized framework, agents are expected to individually procure their energy, while directly negotiating with other market participants. Since distributed power generation is mostly based on non-dispatchable energy resources with zero marginal cost, any proposed decentralized negotiation mechanism needs to account for uncertainties. When operating uncertain assets, decision makers are affected by subjective attitudes towards uncertain payoffs, impacting not only their energy procurement but also the whole market equilibrium. We propose a new definition of fairness in risky environments and show that, in decentralized electricity markets, heterogeneous risk aversion of participants compromises fairness of the resulting market payments. Consequently, we introduce financial contracts as risk hedging mechanisms and evaluate their impact on market equilibrium and payments. We show that by trading financial products, fairness is restored.

Ancient Origins of the Global Variation in Economic Preferences

This paper shows that contemporary population-level heterogeneity in risk aversion, time preference, altruism, positive reciprocity, negative reciprocity, and trust partly traces back to the structure of the migration patterns of our very early ancestors. To document this pattern, we link differences in preferences between populations to the length of time elapsed since the ancestors of the respective groups broke apart from each other, as proxied by genetic and linguistic distance measures. Preference differences are significantly increasing in ancestral distance in both cross-country regressions and within-country analyses across groups of migrants.

Dynamic asset allocation with relative wealth concerns in incomplete markets

In dynamic portfolio choice problems, stochastic state variables such as stochastic volatility lead to adjustments of the optimal stock demand referred to as hedge terms or Merton-Breeden terms. By deriving an explicit solution in a two-agent framework with a stochastic opportunity set, we show that relative wealth concerns give rise to new hedge terms beyond the ordinary ones. This is because the agents hedge against both exogenous changes in the state variable and endogenous decisions of the other agent. Depending on the parametrization of the model, these new terms can significantly change the investors’ hedging demands. We also show that both heterogeneity in risk aversion or relative wealth concerns can have similar effects on the heterogeneity in portfolio decisions. Formally, we study a non-cooperative, non-zero sum stochastic differential game for which we prove a verification theorem in a setting with an unspanned state variable.

On the Existence of Positive Equilibrium Profits in Competitive Screening Markets

We assume a fixed number of symmetric firms, competition in prices, constant returns to scale and frictionless consumer choices. Consumers differ in their preferences and profitability (e.g., due to heterogeneous risk aversion and loss probabilities), which creates adverse selection. Firms can offer multiple contracts to screen individuals, in equilibrium and in any deviation. We show that equilibrium profits vanish if each consumer has a unique optimising bundle at equilibrium prices or, more generally, if there exists a linear ordering over of contracts that dictates the preferences of firms whenever consumers are indifferent between multiple optimal contracts. For instance, equilibrium profits vanish if the marginal rate of substitution of quality for price is sharper for profit than for utility. In particular, profit also vanishes if utility equals the sum of (negative) profit, and a surplus (eg, due to risk aversion). We pro- vide examples of economies where there exists an equilibrium with strictly positive profit and show that these examples are robust (hold for an open set of economies).

Heterogeneous Risk-Aversion among Bidders

We study asymmetric first-price procurements with unobserved heterogeneity and asymmetric risk-aversion. For this model, we propose a new empirical method that allows us to predict the expected procurement cost at any reserve price. Being able to perform such detailed counterfactual analysis is necessary to determine the cost-minimizing reserve prices and measure the associated inefficiencies. Using new data from public procurements in Russia for four different kinds of jobs, we find no unobserved heterogeneity, but find bidder-asymmetry in both costs and risk-aversion that vary across the jobs. We find that bidders are highly risk-averse and choosing non-binding reserve prices would minimize procurement costs, whereas assuming risk neutrality would have generated larger costs and lower efficiency. Assuming identical risk-aversion would also mislead policy analysis.

The Equity Premium and the One Percent

AbstractWe show that in a general equilibrium model with heterogeneity in risk aversion or belief, shifting wealth from an agent who holds comparatively fewer stocks to one who holds more reduces the equity premium. From an empirical view, the rich hold more stocks, so inequality should predict excess stock market returns. Consistent with our theory, we find that when the U.S. top ($\textrm{e.g.}$, 1%) income share rises, subsequent 1-year excess market returns significantly decline. This negative relation is robust to controlling for classic return predictors, predicting out-of-sample, and instrumenting inequality with estate tax rate changes. It also holds in international markets.Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Dynamic Asset Allocation with Relative Wealth Concerns in Incomplete Markets

In dynamic portfolio choice problems, stochastic state variables such as stochastic volatility lead to adjustments of the optimal stock demand referred to as hedge terms or Merton-Breeden terms. By deriving an explicit solution in a multi-agent framework with a stochastic opportunity set, we show that relative wealth concerns give rise to new hedge terms beyond the ordinary ones. This is because the agents hedge against both exogenous changes in the state variable and endogenous decisions of the other agent. Depending on the parametrization of the model, these new terms can significantly change the investors' hedging demands. We also show that both heterogeneity in risk aversion or relative wealth concerns can have similar effects on the heterogeneity in portfolio decisions. Formally, we study a non-cooperative, non-zero sum stochastic differential game for which we prove a verification theorem in a setting with an unspanned state variable.