Price volatility and risk with non-separability of preferences

This paper studies the relationship between the systematic risk of financial instruments and the volatility of their equilibrium prices in a two-period stochastic asset valuation model. Whereas there is no link between the relative risk of assets and their price volatility in standard representative-agent models with additively-separable preferences, in this model with non-separable preferences a riskier asset can have higher or lower price volatility than a safe asset depending on the intertemporal changes in risk aversion. If individual preferences exhibit risk substitutability (i.e. future relative risk aversion decreases with higher current consumption), then the riskier asset has a more volatile price than the less risky asset. Agents’ risk complementarity (i.e. increasing future relative risk aversion with higher current consumption), on the other hand, implies an inverse relationship between the relative riskiness of assets and the volatility of their prices.

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