Can Heterogeneity in Preferences Explain the Dynamics of Asset Prices?

Description

Recent studies show that the Sharpe ratio that measures risk-return trade-off is not constant but is actually quite volatile and strongly countercyclical. Existing consumption-based asset pricing models that are able to match the average level of the Sharpe ratio are not able to explain its dynamic behavior. In this project, we propose a consumption-based asset pricing model with heterogeneous agents who have different preferences. Agents with higher risk aversion consume more and invest less in risky assets relative to the low risk aversion agents. In equilibrium the Sharpe ratio is determined by the consumption shares of the agents. These consumption shares fluctuate with aggregate consumption, but are much more volatile than aggregate consumption. The Sharpe ration also demonstrates countercyclical behavior because in equilibrium it is negatively correlated with the consumption share of the less risk averse agents.