Asset Prices and the Heterogeneous Impact of News

Abstract

This paper analyzes a general equilibrium exchange economy with a continuum of agents who have "catching up with the Joneses" preferences and differ with respect to the curvature of their utility functions and - as a peculiarity - the impact of news about uncertainty. The dynamic redistribution of wealth among the agents generates endogenously the state-dependent preferences of the representative agent and the variation in the pricing kernel volatility, i.e. the price of risk. The model exhibits many of the empirically observed properties of the unconditional and conditional moments of stock returns. Indeed, the new source of heterogeneity has a strong impact on asset prices whereas heterogeneity in risk aversion has just a marginal effect once it is estimated from data. In particular the heterogeneous impact of news helps in explaining the equity premium and risk-free rate puzzles, the high and countercyclical Sharpe ratio, the long-horizon predictability of excess returns and the GARCH and leverage effects in return volatility.

Keywords: Heterogeneous preferences, general equilibrium, closed-form expression, equity premium, countercyclical Sharpe ratio

JEL Classification: G12, G13