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The Economics of Risk and Time

Book · January 2001

DOI: 10.7551/mitpress/2622.001.0001 · Source: RePEc

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The Economics of Risk
and Time

Christian Gollier

The MIT Press

Cambridge, Massachusetts
London, England
 Contents

Preface xv
Acknowledgments xix

I General Theory 1

1 The Expected Utility Model 3

1.1 Simple and Compound Lotteries 3
1.2 Axioms on Preferences under Uncertainty 4
1.3 The Expected Utility Theorem 6
1.4 Critics of the Expected Utility Model 9
1.4.1 The Allais Paradox 10
1.4.2 The Allais Paradox and Time Consistency ll
1.5 Concluding Remark 14
1.6 Exercises and Extensions 14

2 Risk Aversion 17
2.1 Characterization of Risk Aversion 17
2.2 Comparative Risk Aversion 18
2.3 Certainty Equivalent and Risk Premium 20
2.4 The Arrow-Pratt Approximation 21
2.5 Decreasing Absolute Risk Aversion 24
2.6 Some Classical Utility Functions 25
2.7 Test for Your Own Degree of Risk Aversion 29
2.8 An Application: The Cost of Macroeconomic
Risks 32
2.9 Conclusion 34
2.10 Exercises and Extensions 35
 Contents
vi

3 Change in Risk 39
3.1 The Extremal Approach 40
3.2 Second-Order Stochastic Dominance 42
3.3 Diversification 45
3.4 First-Order Stochastic Dominance 46
3.5 Concluding Remark 47
3.6 Exercises and Extensions 48

II The Standard Portfolio Problem 51

4 The Standard Portfolio Problem 53

4.1 The Model and Its Basic Properties 53
4.2 The Case of a Small Risk 55
4.3 The Case of HARA Functions 57
4.4 The Impact of Risk Aversion 58
4.5 The Impact of a Change in Risk 59
4.6 Concluding Remark 61
4.7 Exercises and Extensions 62

5 The Equilibrium Price of Risk 65

5.1 A Simple Equilibrium Model for Financial
Markets 65
5.2 The Equity Premium Puzzle 68
5.3 The Equity Premium with Limited Participation 71
5.4 The Equity Premium and the Integration of
International Financial Markets 73
5.5 Conclusion 75
5.6 Exercises 76

III Some Technical Tools and Their Applications 79

6 A Hyperplane Separation Theorem 81

6.1 The Diffidence Theorem 81
6.2 Link with the Jensen's Inequality 88
6.3 Applications of the Diffidence Theorem 89
6.3.1 Diffidence 89
6.3.2 Comparative Diffidence 90
6.3.3 Central Risk Aversion 91
63.4 Central Riskiness 92
Contents vii

6.4 The Covariance Rule 94

6.5 Conclusion 95
6.6 Exercises and Extensions 96

7 Log-Supermodularity 99
7.1 Definition 99
7.2 Log-Supermodularity and Single Crossing 102
7.2.1 A Theoretical Result 102
7.2.2 Applications to the Standard Portfolio
Problem 103
7.2.3 Jewitt's Preference Orders 104
7.3 Expectation of a Log-Supermodular Function 105
7.3.1 A Theoretical Result 105
7.3.2 Two Applications 106
7.4 Concluding Remark 107
7.5 Exercises and Extensions 107
7.6 Appendix 108

IV Multiple Risks 111

8 Risk Aversion with Background Risk 113

8.1 Preservation of DARA 114
8.2 The Comparative Risk Aversion Is Not Preserved 117
8.3 Extensions with Dependent Background Risk 119
8.3.1 Affiliated Background Risk 119
8.3.2 The Comparative Risk Aversion in the Sense of
Ross 121
8.4 Conclusion 123
8.5 Exercises and Extensions 124

9 The Tempering Effect of Background Risk 125

9.1 Risk Vulnerability 126
9.2 Risk Vulnerability and Increase in Risk 130
9.2.1 Increase in Background Risk 130
9.2.2 Increase in the Endogenous Risk 130
9.3 Risk Vulnerability and the Equity Premium
Puzzle 131
9.4 Generalized Risk Vulnerability 132
9.5 Standardness 135
vm Contents

9.6 Conclusion 138

9.7 Exercises and Extensions 139

10 Taking Multiple Risks 141

10.1 The Interaction between Asset Demand and Small
Gambles 142
10.2 Are Independent Assets Substitutes? 144
10.2.1 The i.i.d. Case 144
10.2.2 The General Case 150
10.3 Conclusion 153
10.4 Exercises and Extensions 153

11 The Dynamic Investment Problem 155

11.1 Static versus Dynamic Optimization 157
11.2 The Standard Portfolio Problem 158
11.2.1 The Model 158
11.2.2 The HARA Case 160
11.2.3 A Sufficient Condition for Younger People to Be
More Risk-Averse 161
11.3 Discussion of the Results 165
11.3.1 Nonlinear Risk Tolerance 165
11.3.2 Nondifferentiable Marginal Utility 166
11.4 Background Risk and Time Horizon 168
11.4.1 Investors Bear a Background Risk at
Retirement 168
11.4.2 Stationary Income Process 171
11.5 Final Remark 172
11.6 Exercises and Extensions 173

12 Special Topics in Dynamic Finance 175

12.1 The Length of Periods between Trade 175
12.2 Dynamic Discrete Choice 179
12.3 Constraints on Feasible Strategies 183
12.4 The Effect of a Leverage Constraint 185
12.4.1 The Case of a Lower Bound on the Investment in
the Risky Asset 185
12.4.2 The Case of an Upper Bound on the Investment
in the Risky Asset 187
12.5 Concluding Remarks 190
12.6 Exercises and Extensions 190
Contents

V The Arrow-Debreu Fortfolio Problem 193

13 The Demand for Contingent Claims 195

13.1 The Model 196
13.2 Characterization of the Optimal Portfolio 197
13.3 The Impact of Risk Aversion 200
13.4 Conclusion 201
13.5 Exercises and Extensions 202

14 Risk on Wealth 205

14.1 The Marginal Propensity to Consume in
State n 206
14.2 The Preservation of DARA and IARA 208
14.3 The Marginal Value of Wealth 210
14.4 Aversion to Risk on Wealth 211
14.5 Concluding Remark 212
14.6 Exercises and Extensions 212

VI Consumption and Saving 215

15 Consumption under Certainty 217

15.1 Time Separability 217
15.2 Exponential Discounting 218
15.3 Consumption Smoothing under Certainty 219
15.4 Analogy with the Portfolio Problem 221
15.5 The Social Cost of Volatility 224
15.6 The Marginal Propensity to Consume 226
15.7 Time Diversification and Self-Insurance 227
15.8 Concluding Remark 232
15.9 Exercises and Extensions 232

16 Precautionary Saving and Prudence 235

16.1 Prudence 235
16.2 The Demand for Saving 239
16.3 The Marginal Propensity to Consume under
Uncertainty 239
16.3.1 Does Uncertainty Increase the MPC? 240
16.3.2 Does Uncertainty Make the MPC Decreasing in
Wealth? 241
16.4 More Than Two Periods 242
 Contents

16.4.1 The Euler Equation 242

16.4.2 Multiperiod Precautionary Saving 244
16.5 Illiquid Saving under Uncertainty 246
16.6 Conclusion 247
16.7 Exercises and Extensions 248

17 The Equilibrium Price of Time 249

17.1 Description of the Economy 250
17.2 The Determinants of the Interest Rate 252
17.2.1 The Interest Rate in the Absence of
Growth 252
17.2.2 The Effect of a Sure Growth 253
17.2.3 The Effect of Uncertainty 254
17.3 The Risk-Free Rate Puzzle 256
17.4 The Yield Curve 258
17.4.1 The Pricing Formula 258
17.4.2 The Yield Curve with HARA Utility
Functions 260
17.4.3 A Result When There Is No Risk of
Recession 261
17.4.4 Exploring the Slope of the Yield Curve When
There Is a Risk of Recession 264
17.5 Concluding Remark 267
17.6 Exercises and Extensions 268

18 The Liquidity Constraint 269

18.1 Saving as a Buffer Stock 270
18.2 The Liquidity Constraint Raises Risk Aversion 272
18.3 The Liquidity Constraint and the Shape of Absolute
Risk Tolerance 273
18.4 Numerical Simulations 277
18.5 Conclusion 279
18.6 Exercises and Extensions 281

19 The Saving-Portfolio Problem 285

19.1 Precautionary Saving with an Endogenous Risk 285
19.1.1 The Case of Complete Markets 285
19.1.2 The Case of the Standard Portfolio
Problem 287
19.1.3 Discussion of the Results 288
Contents

19.2 Optimal Portfolio Strategy with Consumption 290

193 The Merton-Samuelson Model 291
19.4 Concluding Remark 295
19.5 Exercises and Extensions 295

20 Disentangling Risk and Time 297

20.1 The Model of Kreps and Porteus 298
20.2 Preferences for an Early Resolution of
Uncertainty 299
20.3 Prudence with Kreps-Porteus Preferences 300
20.4 Conclusion 302
20.5 Exercises and Extensions 303

VII Equilibrium Prices of Risk and Time 305

21 Efficient Risk Sharing 307

21.1 The Case of a Static Exchange Economy 307
21.2 The Mutuality Principle 309
21.3 The Sharing of the Social Risk 311
21.3.1 Decomposition of the Problem 311
21.3.2 The Veil of Ignorance 312
21.3.3 Efficient Sharing Rules of the Macro Risk 312
21.3.4 A Two-Fund Separation Theorem 314
21.3.5 The Case of Small Risk per Capita 315
21.4 Group's Attitude toward Risk 316
21.4.1 The Representative Agent 316
21.4.2 Arrow-Lind Theorem 317
21.4.3 Group Decision and Individual Choice 317
21.5 Introducing Time and Investment 319
21.6 A Final Remark: The Concavity of the Certainty
Equivalent Functional 321
21.7 Conclusion 323
21.8 Exercises and Extensions 323
21.9 Appendix 325

22 The Equilibrium Price of Risk and Time 327

22.1 An Arrow-Debreu Economy 327
22.2 Application of the First Theorem of Welfare
Economics 328
22.3 Pricing Arrow-Debreu Securities 329
xii Contents

22.4 Pricing by Arbitrage 330

22.5 The Competitive Price of Risk 332
22.6 The Competitive Price of Time 334
22.7 Spot Markets and Markets for Futures 335
22.8 Corporate Finance in an Arrow-Debreu Economy 337
22.9 Conclusion 339
22.10 Exercises and Extensions 340

23 Searching for the Representative Agent 343

23.1 Analytical Solution to the Aggregation Problem 344
23.2 Wealth Inequality, Risk Aversion, and the Equity
Premium 345
23.3 Wealth Inequality and the Risk-Free Rate 347
23.3.1 The Consumption Smoothing Effect 348
23.3.2 The Precautionary Effect 349
23.4 Conclusion 351
23.5 Exercises and Extensions 352

VIII Risk and Information 355

24 The Value of Information 357

24.1 The General Model of Risk and Information 357
24.1.1 Structure of Information 357
24.1.2 The Decision Problem 358
24.1.3 The Posterior Maximum Expected Utility Is
Convex in the Vector of Posterior
Probabilities 359
24.2 The Value of Information ls Positive 362
24.3 Refining the Information Structure 364
24.3.1 Definition and Basic Characterization 364
24.3.2 Garbling Messages and the Theorem of
Blackwell 366
24.3.3 Location Experiments 371
24.4 The Value of Information and Risk Aversion 373
24.4.1 A Definition of the Value of Information 373
24.4.2 A Simple Illustration: The Gambler's
Problem 374
24.4.3 The Standard Portfolio Problem 378
24.5 Conclusion 379
Contents xiii

24.6 Exercises and Extensions 380

24.7 Appendix 382

25 Decision Making and Information 383

25.1 A Technique for the Comparative Statics of More
Informativeness 383
25.2 The Portfolio-Saving Problem 386
25.3 A Digression: Scientific Uncertainty, Global Warming,
and the "Precautionary Principle" 389
25.4 The Saving Problem with Uncertain Returns 390
25.5 Precautionary Saving 392
25.6 The Value of Flexibility and Option Value 393
25.7 Predictability and Portfolio Management 397
25.7.1 Exogenous Predictability 399
25.7.2 Endogenous Predictability and Mean-
Reversion 400
25.8 Conclusion 405
25.9 Exercises and Extensions 405

26 Information and Equilibrium 407

26.1 Hirshleifer Effect 407
26.2 Information and the Equity Premium 413
26.3 Conclusion 418
26.4 Exercises and Extensions 418
26.5 Appendix 420

27 Epilogue 423
27.1 The Important Open Questions 423
27.1.1 The Independence Axiom 423
27.1.2 Measures of Risk Aversion 424
27.1.3 Qualitative Properties of the Utility
Function 425
27.1.4 Economics of Uncertainty and Psychology 426
27.2 Conclusion 427

Bibliography 429
Index of Lemmas and Propositions 441
Index of Subjects 443

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