Instability of Financial Markets and Preference Heterogeneity.pdfVIP

Hindawi Publishing Corporation Advances in Decision Sciences Volume 2010, Article ID 791025, 27 pages doi:10.1155/2010/791025 Research Article Instability of Financial Markets and Preference Heterogeneity ¨ 1 ¨ 2 Gunter Franke and Erik Luders 1 Department of Economics, University of Konstanz, 78457 Konstanz, Germany 2 McKinsey Company, Inc., Taunustor 2, 60311 Frankfurt/Main, Germany Correspondence should be addressed to Gunter Franke, guenter.franke@uni-konstanz.de ¨ Received 22 December 2009; Accepted 7 March 2010 Academic Editor: Wing-Keung Wong Copyright q 2010 G. Franke and E. Luders. This is an open access article distributed under ¨ the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. This paper presents a simple rational expectations model of intertemporal asset pricing relating instability of stock return characteristics to heterogeneity in investor preferences. Heterogeneity is likely to generate declining aggregate relative risk aversion. This leads to variability in expected asset returns, volatility, and autocorrelation. The stronger this variability is, the more heterogeneous preferences are, implying more instability of financial markets. Stock market crashes may be observed if relative risk aversion differs strongly across investors. 1. Introduction The last twenty five years witnessed various sudden shifts in valuation so that instability of financial markets does not seem to be the exception but the rule. The stock market cras