Behavioral Models of Dynamic Asset Pricing
The recently developed asset pricing models with habit formation and loss aversion seem to go a long way to explain the risk-free interest rate, equity premium and Sharpe ratio in amore plausible way than the earlier consumption based asset pricing models. In particular, the asset pricing model with loss aversion has great potentials not only to match the dynamics of equity prices but other markets with volatile price movements and risky returns as well.177 This new approach moves beyond the consumption based asset pricing model and allows to de-link consumption and asset returns. It also nicely explains the time varying risk aversion by referring to the actual gains and losses of financial wealth. This view of gains and losses giving rise to a time varying risk aversion, is not only relevant for the individual investor but in particular seems to be very important for institutional investors such as pension funds (that had guaranteed a certain return), universities (that have large operating costs) and foundations (that grant fellowships). For those institutions painful adjustment processes have to be enacted, once losses have occurred and thus a time varying risk aversion can easily predicted.
KeywordsRisk Aversion Asset Price Risky Asset Loss Aversion Adjustment Cost
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