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The Risk of Becoming Risk Averse: A Model of Asset Pricing and Trade Volumes

Fernando Alvarez and Andrew Atkeson
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Fernando Alvarez: University of Chicago
Andrew Atkeson: Federal Reserve Bank of Minneapolis

No 577, Staff Report from Federal Reserve Bank of Minneapolis

Abstract: We develop a new general equilibrium model of asset pricing and asset trading volume in which agents’ motivations to trade arise due to uninsurable idiosyncratic shocks to agents’ risk tolerance. In response to these shocks, agents trade to rebalance their portfolios between risky and riskless assets. We study a positive question — When does trade volume become a pricing factor? — and a normative question — What is the impact of Tobin taxes on asset trading on welfare? In our model, economies in which marketwide risk tolerance is negatively correlated with trade volume have a higher risk premium for aggregate risk. Likewise, for a given economy, we find that assets whose cash flows are concentrated on states with high trading volume have higher prices and lower risk premia. We then show that Tobin taxes on asset trade have a first-order negative impact on ex-ante welfare, i.e., a small subsidy to trade leads to an improvement in ex-ante welfare. Finally, we develop an alternative version of our model in which asset trade arises from uninsurable idiosyncratic shocks to agents’ hedging needs rather than shocks to their risk tolerance. We show that our positive results regarding the relationship between trade volume and asset prices carry through. In contrast, the normative implications of this specification of our model for Tobin taxes or subsidies depend on the specification of agents’ preferences and non-traded endowments.

Keywords: Liquidity; Trade volume; Asset pricing; Tobin taxes (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-fmk and nep-upt
Date: 2018-12-31
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:577

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DOI: 10.21034/sr.577

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