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

Author(s): Pietro Veronesi
Publication Date: September 2001
Keyword(s): asset pricing, state dependent prefereneces, uncertainty aversion
JEL(s): D81, G12
Programme Areas: Financial Economics
Link to this Page: http://www.cepr.org/pubs/dps/DP2965

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.