Changing Risk Aversion: Linking the Cross Section and Time-Variation in expected Returns

Finance

IFA Working Paper

1997

This paper examines the cross-sectional pricing implications of the changing-risk-aversion explanation of stock return predictability. We present a model in which investors have locally decreasing risk aversion. In equilibrium, we show that an asset's expected excess return is proportional to the return's cross-covariance with the future expected return on a reference asset. The pricing equation does not require wealth or consumption data, holds with incomplete markets, and links the cross-sectional and time-series properties of expected returns that are maximally correlated with consumption. Some empirical support for the model is found using size decile stock portfolio returns, bond returns, and returns on several 'managed' portfolios.

Institute of Finance and Accounting

FIN 255

IFA Working Paper

No