There has been much talk about risk aversion indices rising – indicating that investors are willing to hold to low yielding savings, cash or cash-equivalents instead of high yielding investments. In essence, as the Mafia says, investors have been hitting the mattresses.
- A fictional investor has a utility function with consumption as a variable and risk aversion and discount factor as constants.
- This investor has intertemporal budge constraint – where delayed gratification is the theme. i.e., decide to consume today or consume tomorrow by investing in risky asset.
- Maximize the expected utility subject to this constraint and arrive at equilibrium conditions for consumption, S&P 500 returns, t-bills returns and risk aversion parameters.
- The equilibrium conditions capture a fictitious state where marginal cost from investing today in risky asset is matched by the marginal benefit of consumption tomorrow.
- Assume t-bill returns and S&P 500 returns are normally distributed.
- Using market data for returns, using root-finding algorithms, solve for the discount factors and risk aversion.
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