Robust Permanent Income and Pricing

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The authors offer an explanation of the equity premium puzzle (that the observed market price of risk implies an implausibly high degree of risk aversion on the part of expected-utility maximizing agents) by appealing to risk-sensitivity in a representative-agent dynamic economy, and the implied market price of risk is obtained as a function of the risk-sensitivity parameter alone. Equivalence with a formulation based on preference for robustness is also shown. The starting point of the paper is the result that as far as consumption-saving decisions are concerned, expected utility maximisers are indistinguishable from risk-sensitive agents with lower discount factors; the intuition is that risk sensitivity strengthens the precautionary motive for saving, but this change is offset by a lesser concern for the future. Given this, the authors consider different kinds of agents -- expected utility maximisers and others with differing degrees of risk sensitivity -- all generating the consumption-investment time series corresponding to US 1970-1996 data, and show that risk sensitivity does have the effects one would expect on the market price of risk. To understand this implication consider the familiar equation expressing the current price of an asset as the expectation, conditional on available information, of the product of the asset's next period gross return (dividend plus selling price) times a (stochastic) discount factor, say \(m\); then the market price of risk is the (conditional) standard deviation of \(m\) divided by its mean. The authors show that risk-sensitivity results in a muliplicative distortion of \(m\) which leaves its mean unaltered but amplifies its standard deviation. Equivalent results are shown to hold under the alternative, robustness-based interpretation.




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