The Implications of First-Order Risk Aversion for Asset Market Risk Premiums

Abstract

Existing general equilibrium models based on traditional expected utility preferences have been unable to explain the excess return predictability observed in equity markets, bond markets, and foreign exchange markets. In this paper, we abandon the expected-utility hypothesis in favor of preferences that exhibit first-order risk aversion. We incorporate these preferences into a general equilibrium two-country monetary model, solve the model numerically, and compare the quantitative implications of the model to estimates obtained from U.S. and Japanese data for equity, bond and foreign exchange markets. Although increasing the degree of first-order risk aversion substantially increases excess return predictability, the model remains incapable of generating excess return predictability sufficiently large to match the data. We conclude that the observed patterns of excess return predictability are unlikely to be explained purely by time-varying risk premiums generated by highly risk averse agents in a complete markets economy.