Preference for Flexibility and the Pricing of Assets

We consider agents who have a dynamic preference for flexibility, as in Krishna and Sadowski [2012] (KS). Such agents are uncertain about their future utilities. We first consider a version of the Lucas tree economy, where the representative agent behaves as in KS and is uncertain about his degree of future risk aversion. We show that in such an economy, the representative agent’s uncertainty about his future risk aversion drives price volatility (in the sense of second order stochastic dominance). We then consider the Lucas tree economy and add an additional market stage, where the productive asset cannot be traded. We show that a representative agent with a higher degree of uncertainty about his future risk aversion implies less investment and more price volatility in this economy.