Thursday 23rd February 2012 – 12:30 to 13:30

Speaker: Harjoat Bhamra (Imperial College, London and University of British Columbia)

In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have “catching up with the Joneses” utility functions and differ with respect to both their current beliefs (because of differences in priors) and their preference parameters for time discount, risk aversion, and habit. We solve in closed form for the following quantities: optimal consumption and portfolio policies of individual agents; the state price density, the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; and, the term structure of interest rates. Our solution allows us to identify the strengths and limitations of the model with heterogeneity in both preferences and beliefs. This model generates stock-market returns that are characterized by skewness, excess kurtosis, volatility in excess of that of fundamentals, with conditional volatility of returns being countercyclical. Both heterogeneity in beliefs and preferences reduce the level of the risk-free interest rate. We also identify the conditions under which the equity market risk premium is high. The methodology we develop is sufficiently general that, as long as markets are complete, it can be applied to: models set in discrete or continuous time; to endowment processes that are in the exponential affine jump-diffusion class; and, to settings with Bayesian updating of beliefs.

Joint with Raman Uppal.

Part of the OMI Seminar Series