The Implications of First-Order Risk Aversion for Asset Market Risk Premiums

In this paper, we ask whether high levels of risk aversion can explain the observed predictability of excess returns within the context of a frictionless, representative agent model. In order to give this explanation the best chance for success, we assume that agents' preferences display first-order risk aversion. This preference specification implies that agents respond more strongly to consumption risk than would be the case under conventional Von Neuman- Morgenstern preferences. Yet, even this more extreme form of risk aversion can explain only a small fraction of the predictability of excess returns found in the data. Furthermore, we find that the slope coefficients in equations predicting excess returns do not increase monotonically with increased risk aversion. The level of risk aversion affects not only the variability of risk premiums, but also the second moments of other endogenous variables which affect predictability. The resulting implications for the signs and magnitudes of these slope coefficients are ambiguous. Taken together, the results of this paper suggest that the predictability of excess returns cannot be fully explained simply by modifying preference assumptions. A more promising approach may be to abandon the assumption that the empirical distribution in the data set is a good proxy for agents' subjective distribution over future variables. Rational optimizing models that do not impose this assumption include learning models, models with peso- problems, and some models with regime switching. It is hoped that these alternative approaches will have more success in explaining excess-return predictability than approaches based solely on modeling agents' aversion to consumption risk