HETEROGENEITY IN RISK PREFERENCES LEADS TO STOCHASTIC VOLATILITY

This paper studies the price processes of a claim on terminal endowment and of a claim on firm book value when the underlying variables follow a bivariate geometric Brownian motion. If the state-price process is multiplicatively separable into time and endowment functions, our main result shows that...

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Bibliographic Details
Published in:International journal of theoretical and applied finance 2018-09, Vol.21 (6), p.1850035
Main Author: LEISEN, DIETMAR P. J.
Format: Article
Language:English
Subjects:
Economic models
Endowment
Power
Risk
Risk aversion
Risk factors
Risk preferences
Volatility
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Summary:This paper studies the price processes of a claim on terminal endowment and of a claim on firm book value when the underlying variables follow a bivariate geometric Brownian motion. If the state-price process is multiplicatively separable into time and endowment functions, our main result shows that firm (endowment) price volatility is stochastic (state-dependent) if, and only if, the endowment function is not a power function. In a pure exchange economy populated by two agents with constant relative risk aversion (CRRA) preferences we confirm the separability, and we show furthermore that firm (endowment) price volatility is stochastic (state-dependent) if, and only if, both agents are heterogeneous in risk-preferences.
ISSN:0219-0249
1793-6322
DOI:10.1142/S0219024918500358