Asset Pricing with Loss Aversion∗

Using standard preferences for asset pricing has not been very successful in matching asset price characteristics such as the risk-free interest rate, equity premium and the Sharpe ratio to time series data. Behavioral finance has recently proposed more realistic preferences such as those with loss aversion. Research is starting to explore the implications of behaviorally founded preferences for asset price characteristics. Encouraged by some studies of Benartzki and Thaler (1995) and Barberis et al. (2001) we study asset pricing with loss aversion in a production economy. Here, we employ a stochastic growth model and use a stochastic version of a dynamic programming method with adaptive grid scheme to compute the above mentioned asset price characteristics of a model with loss aversion in preferences. As our results show using loss aversion we get considerably better results than one obtains from pure consumption-based asset pricing models including the habit formation variant. JEL classifications: C60, C61, C63, D90,G12 keywords: behavioral finance, loss aversion, stochastic growth models, asset pricing and stochastic dynamic programming We want to thank Blake LeBaron, David Backus, Buz Brock, Richard Thaler and Roman Frydman. We want to thank the participants of seminars at the German Bundesbank, Bielefeld University, Chuo and Meiji Universities, Tokyo and two referees of the Journal for their comments. Mathematisches Institut, Fakultät für Mathematik und Physik, Universität Bayreuth, 95440 Bayreuth, Germany, email: [email protected] Center for Empirical Macroeconomics, University of Bielefeld, 33501 Bielefeld, Germany; and Dept. of Economics, New School, email: [email protected]