Asset Returns and Economic Conditions
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This note assesses the factor structure method for capturing variations in a large number of economic indicators and the use of the resulting factors to model the agent reference level in preferences. The resulting model captures the dynamics of security returns including time-varying risk aversion, small relative risk aversion and an equity premium compatible with the actual equity premium, thus explaining many of the asset-pricing puzzles.
These findings contribute to the literature, which tackles empirical shortcomings of consumption-based capital asset pricing models (C-CAPM) by modifying investor’s preferences to account for other economic risks in the reference level. This notion of reference-dependent preferences has its origins in the concept of loss aversion where people care not only about absolute consumption, but also about consumption relative to a reference point. In this case, investors are assumed to be more concerned about losses relative to this reference level than...