First-Order Risk Aversion, Heterogeneity, and Asset Market Outcomes




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    • Chapman is at Boston College and Polkovnichenko is at the University of Texas at Dallas. Polkovnichenko acknowledges financial support from a Business and Economics Research Grant of the McKnight Foundation at the University of Minnesota. We would like to thank an anonymous referee; Nick Barberis; John Campbell; Wayne Ferson; Iraj Fooladi; Evan Gatev; Campbell Harvey (the editor); Erzo Luttmer, Maureen O'Hara; Neil Pearson; Bryan Routledge; Jeremy Stein; and workshop participants at Boston College, Harvard University, McGill University, and the 2005 WFA meetings for helpful comments.


We examine a wide range of two-date economies populated by heterogeneous agents with the most common forms of nonexpected utility preferences used in finance and macroeconomics. We demonstrate that the risk premium and the risk-free rate in these models are sensitive to ignoring heterogeneity. This follows because of endogenous withdrawal by nonexpected utility agents from the market for the risky asset. This finding is important precisely because these alternative preferences have frequently been proposed as possible resolutions to various asset pricing puzzles, and they have all been examined exclusively in a representative agent framework.