THE IMPLICATIONS OF FIRST-ORDER RISK-AVERSION FOR ASSET MARKET RISK PREMIUMS

In an effort to explain simultaneously the excess return predictabilit y observed in equity, bond and foreign exchange markets, we incorporat e preferences exhibiting first-order risk aversion into a general equi librium two-country monetary model. When we calibrate the model to US and Japanese data, we find that first-order risk aversion substantiall y increases excess return predictability. However, this increased pred ictability is insufficient to match the data. We conclude that the obs erved patterns of excess return predictability are unlikely to be expl ained purely by time-varying risk premiums generated by highly risk av erse agents in a complete markets economy.