DP2965 | Belief Dependent Utilities, Aversion to State-Uncertainty and Asset Prices

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26/09/2001

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Abstract

This Paper reinterprets standard axioms in choice theory to introduce the concepts of ?belief dependent? utility functions and aversion to ?state-uncertainty?. It shows that this type of preference helps to explain the various stylized facts of asset returns, including a high equity risk premium, a low risk-free rate, a high return volatility, stock return predictability and volatility clustering. In one particular specification consistent with habit formation preferences, I also argue that ?aversion to state-uncertainty? gives rise to ?aversion to long-run risk?, that is, to the uncertainty surrounding the long-run average of future consumption. In order to solve for asset prices and returns under general conditions about the hidden state variable, the Paper also develops a discretization methodology to obtain approximate analytical solutions. In a parsimonious parametrization, I then show that the model calibrated to real consumption generates unconditional moments for asset returns that closely match the empirical ones. Finally, due to the estimated time-variation in the dispersion of the conditional distribution on the drift rate of consumption, the model also generates a time series of conditional return volatility in line with the ex-post integrated volatility of stock returns.