Asset-Pricing Implications of Biologically Based Non-Expected Utility

Emil Iantchev
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Emil Iantchev: Syracuse University

Review of Economic Dynamics, 2013, vol. 16, issue 3, 497-510

Abstract: Results in population ecology suggest that evolutionary successful species should have an adaptive (reference-based) S-shaped utility function that is intrinsically more sensitive to aggregate than uninsured idiosyncratic shocks--the former cannot be diversified demographically. To test the asset-pricing relevance of these ideas, I embed the non-expected utility specification implied by evolutionary theory into an economy with partial risk sharing due to limited commitment. For the benchmark specification (CRRA=6 over gains), Monte Carlo simulations of a Markov growth economy produce the following results: (i) matching the degree of consumption-smoothing in the cross section, the Sharpe ratio for a Lucas tree is 0.33, an increase of 44 percent relative to expected utility; (ii) the risk-free rate is low, stable and counter cyclical, hence equity returns, unlike in the expected utility case, have the correct pattern of predictability; (iii) in the cross section, excess returns across equity classes exhibit both a value premium and a size discount with risk adjusted returns that are at least two times higher than their expected utility counterparts. (Copyright: Elsevier)

Keywords: Recursive utility; Limited commitment; Equity return predictability; Cross-sectional distribution of equity returns (search for similar items in EconPapers)
JEL-codes: D53 D81 E44 G12 (search for similar items in EconPapers)
Date: 2013
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DOI: 10.1010/j.red.2012.08.002

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