Higher Risk Aversion in Older Agents: Its Asset Pricing Implications

Abstract

This paper investigates asset pricing in a three-period overlapping generations (OLG) model economy where each generation lives as young, middle-aged and old. There is one perishable consumption good in the economy and two types of traded securities in the capital market: a bond and a share of equity. Implications for asset pricing and security returns of an increasing risk aversion are explored by allowing each agent's coefficient of relative risk aversion to vary with his age; the middle-aged consumer has a higher aversion to risk than the young and the old consumers are more risk averse than the middle-aged ones. Our model produces high equity premium without requiring very large levels of consumer risk aversion; a result more consistent with the U.S. data. We further modify our model to reflect the U.S. demographic trend of an increasing share of older age group. This new specification generates an even higher equity premium and a lower risk-free rate of return with an added desirable result of a lower standard deviation for the risk premium.