Impact of investor's varying risk aversion on the dynamics of asset price fluctuations

Abstract

While investors' responses to price changes and their price forecast have been identified as one of the major factors contributing to large price fluctuations in financial markets, our study shows that investors' heterogeneous and dynamic risk aversion (DRA) preferences may play a more critical role in understanding the dynamics of asset price fluctuations. We allow an agent specific and time-dependent risk aversion index in a popular power utility function with constant relative risk aversion to construct our DRA model in which we made two key contributions. We developed an approximated closed-form price setting equation, providing a necessary framework for exploring the impact of various agents' behaviors on the price dynamics. The dynamics of each agent's risk aversion index is modeled by a bounded random walk with a constant variance, and such dynamics is incorporated in the price formula to form our DRA model. We show numerically that our model reproduces most of the "stylized" facts observed in the real data, suggesting that dynamic risk aversion is an important mechanism for understanding the dynamics of the financial market and the resultant financial time series. © Springer-Verlag 2006.