Equilibrium Asset Pricing with Epstein-Zin and Loss-Averse Investors

We study multi-period equilibrium asset pricing in an economy with EZ-agents whose preferences for consumption are represented by recursive utility and with LAagents who experience additional utility of trading gains and losses and are averse to losses. We propose an equilibrium gain-loss ratio for stocks and show that the LAagents hold less (more) stocks than the EZ-agents if and only if the LA-agents’ loss aversion degree is larger (smaller) than this ratio. With myopic EZand LA-agents, we prove the existence and uniqueness of the equilibrium and the market dominance of the EZ-agents in the long run. Finally, we find that the equity premiums in this economy and in another economy with a representative agent whose preferences are the average of those of the EZand the LA-agents in the former economy are quantitatively similar if the LA-agents participate in the stock market and can be significantly different otherwise. ∗We thank participants of 2014 INFORMS Annual Meeting at San Francisco and 2014 SIAM Conference on Financial Mathematics and Engineering at Chicago for their comments and suggestions. †Department of Industrial Engineering and Operations Research, Columbia University, S. W. Mudd Building, 500 W. 120th Street, New York, NY 10027, USA. Email: [email protected]. ‡Department of Industrial Engineering and Operations Research, Columbia University, S. W. Mudd Building, 500 W. 120th Street, New York, NY 10027, USA. Email: [email protected].